Subprime Losses Are Big, Exaggerated by Some: John M. Berry

Commentary by John M. Berry

Dec. 27 (Bloomberg) -- As the U.S. savings and loan crisis worsened in the 1980s, analysts tried to top each other's estimates of the debacle's cost to the federal government.

Much the same thing is happening now with losses linked to subprime mortgages, with figures of $300 billion to $400 billion being bandied about.

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.

A loss of $150 billion would be less than 12 percent of the approximately $1.3 trillion in subprime mortgages outstanding. About $800 billion of those are adjustable-rate mortgages, the remainder fixed rate.

Subprime loans represent about an eighth of the value of all U.S. residential mortgages.

In the S&L crisis, Charles A. Bowsher, director of the Government Accountability Office, topped everyone's estimate with $500 billion, though that dubiously included the cost of interest on money borrowed to cover actual losses of $160 billion. That's about $260 billion in 2007 dollars.

This time insured depositors aren't in the picture, so the federal government isn't directly on the hook. But the government will share in losses by private lenders through reduced tax bills on their lowered income.

Now the primary threat to the economy isn't coming from the losses on the mortgages themselves. It's the capital squeeze on the many financial institutions that packaged so many subprime mortgages into so-called structured securities whose value is almost impossible to pin down. That's causing markets to value such securities as if the true losses on subprime mortgages were $300 billion to $400 billion.

Limited Losses

There are two reasons why the losses aren't likely to be so large.

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.

Second, most subprime borrowers aren't going to default. Suppose even one in four does and lenders recover somewhat more than half the mortgage amount. A fourth of $1.3 trillion in subprime mortgages is $325 billion, and a 55 percent recovery would mean a loss of about $145 billion.

To reach a $300 billion loss would require foreclosures on about half of all subprime mortgages with a 55 percent recovery upon sale of the property. And a $400 billion loss would take about a 60 percent foreclosure rate with recovery of about half the value from the sale.

What It Means

According to the Mortgage Bankers Association, in the third quarter, more than 16 percent of all subprime mortgage payments were at least 30 days late, and less than 1 percent of all mortgages involved homes in foreclosure.

What does that mean for the broader economy, particularly consumer spending?

As Glenn Maguire, chief Asia economist for Societe Generale SA in Hong Kong, told an audience in Shanghai on Dec. 12, less than you might think.

The economic repercussions of the housing bust and mortgage woes are limited to a great extent because less than half of American families own a home with a mortgage, he said. Almost a third of all families rent their house or apartment, almost a fourth own and have no mortgage and the vast majority with a mortgage are current in their payments.

Consumer Spending

Even with about a tenth of all subprime mortgages now in foreclosure, only a small share of all American families -- about 0.3 percent -- own a home in foreclosure, he said.

Maguire argued that, given the big increase in home values prior to 2006, the current decline in home prices isn't likely to be a major drag on consumer spending.

It hasn't been much of one so far. The Commerce Department said on Dec. 21 that consumer spending rose a strong inflation- adjusted 0.5 percent in November, and some analysts now expect it to increase at a 2.5 percent annual rate for the quarter.

Comparisons in dollars of constant value between likely subprime losses and those incurred during the S&L crisis indicate the 1980s hit was significantly greater, though the current episode still has a long way to run.

One similarity between the two is that the real-estate problems are concentrated in a handful of states. Both times the two top trouble spots are California and Florida, states with long histories of real-estate speculation.

Where there are concentrations of foreclosures, the amount of money lenders will recover from the sales will be limited. In many other areas, however, the recovery may be considerably larger.

Many financial institutions dealing with securities backed by subprime mortgages have avoided fire sales at severely depressed values. Eventually, the true size of the underlying losses will show.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.) To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net

Last Updated: December 27, 2007 00:16 EST