Friday, March 23, 2007

The Prevalence of Negative Equity

This week The Economist adds to the discussions about the dangers that mortgage defaults may pose for the US economy:
Cracks in the façade

On March 13th the Mortgage Bankers Association reported that 13% of subprime borrowers were behind on their payments. Some 30 of America's subprime lenders have closed their doors in the past three months. The cost of insurance against default for the riskiest tranches of subprime debt has soared. The worst effects may not be felt until the mortgage payments of many borrowers with no equity in their homes rise sharply.

Is this a mere irritant in America's vast economy, or the start of something much worse? Opinion on Wall Street is divided. Most argue that the mortgage mess, though a blight on anyone caught up in it, will not spread... [but] growing numbers of pessimists disagree.
What I find most interesting is this bit of data that The Economist then cites, from a new study by economist Christopher Cagan at First American CoreLogic.
...To try to assess who is right, you need to know the share of mortgages potentially at risk. And you need to understand the channels through which subprime defaults could spread to the wider economy.

...The greatest difficulties threaten borrowers whose house is worth less than their mortgage. Just under 7% of all American homeowners had this “negative equity” at the end of December 2006 estimates Mr Cagan, using a sample of 32m houses (see chart 1). Among recent homebuyers, the share is even higher: 18% of all people who took mortgages out in 2006 now have negative equity. A quarter of all mortgages due to reset in 2008 are in the same miserable state (see chart 2).

...The direct damage to Wall Street is likely to be modest. A repossessed property will eventually be sold, albeit at a discount. As a result, Mr Cagan's estimate of $326 billion of repossessed mortgages translates into roughly $112 billion of losses, spread over several years. Even a loss several times larger than that would barely ruffle America's vast financial markets: about $600 billion was wiped out on the stockmarkets as share prices fell on February 27th.
That's where I have to disagree. There's a big difference between the market value of publicly traded US companies fluctuating by a hundred billion dollars, and banks charging losses of a hundred billion dollars directly against their equity capital. When banks have to dig into their capital to cover losses, they have less money left to support lending activities, which they then have to curtail. As my look at bank capitalization showed the other day, it seems plausible that losses of $100-$200 billion on bad mortgages could be enough to have a serious impact on bank behavior -- particularly if the economy is slowing or in recession at the same time.

The sky is not falling (yet); but neither do I take comfort from this type of data.


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