Thoughts on subprime & the economy

Fred Wilson wrote a great article recently, “Hitting the Reset Button on Mortgages” with examples that clearly deciphers what’s actually going on. His thoughts on the impact of the Fed’s decision to bail out financial institutions compelled me to give more thought to the subprime mess and motivated me to write this post. I’ll briefly summarize a few key points but encourage you to read Fred’s article instead:

  •  Lenders (banks) are trading in their non-performing, subprime backed, loans & bonds for federally insured loans & realizing a loss on the value of the loans
  • If the gov’t didn’t insure these loans, then the lenders will be forced to foreclose on the mortgages for liquidity & send homeowners into the rental market
  • Gov’t insurance of the non-performing loans allows homeowners to stay in their homes and alleviates some of the banks’ liquidity problems – this is good because the home owners will continue to pay a portion of their mortgages (Fred’s example says home owners will pay $1200 instead of the $1500 they’re supposed to pay)
  • This also keeps housing prices from plummeting from an excess of inventory if you start foreclosing – another plus.

This all sounds good if three things are true:

  1. the gov’t can accurately set the value of these non-performing loans
  2. we are at the bottom of this subprime fallout
  3. homeowners will continue to pay a significant portion of their mortgages.

To the 1st point, I’m not so confident that these loans can be accurately priced because there’s no market for them. But, because there are tangible underlying assets (the land & the house), you can safely assume that once you lower the price enough, people will buy them. To use an extreme example, if you sell a house for $1, the checkout line will be longer than the line for iPhones. Still, how can the gov’t accurately assess the value? The most accurate way to do this is to have the individual homes appraised, but that doesn’t sound reasonable.

Secondly, this article is largely true if you believe we’ve reached the bottom of this crisis, but what if we haven’t? If the government insures these loans at a value of $x, what happens if the value declines another 20-30%? Would the government be forced to foreclose on those mortgages, cut back on other fiscal budgets, or issue more debt and continue to hold onto these garbage loans? Regardless, the impact on the US economy will be catastrophic. Stocks are also getting beaten down and companies look to slash jobs as a way to reduce cost & boost earnings/valuation. Low skill level jobs are usually the first to go so a subset of subprime homeowners will no longer be able to pay any of their mortgages. This creates an excess of inventory on the market as homeowners are forced to foreclose or sell at a loss to downgrade. At that point, would the gov’t have to take a significant loss to liquidate these homes. On top of that, these former homeowners will be collecting unemployment (though that money comes out of state tax money, not federal) – one would still beg the question as to what would happen to the US economy if home values & employment continues to decline. How much debt can the government float before they go belly up too?

Third, it’s great if the gov’t can insure these bad loans, allow the homeowners to stay put and continuing paying a portion of their mortgages. Paying $1200 instead of $1500/month is still better than nothing, but how much are people actually paying? There’s got to be a threshold where it makes more sense to foreclose than to keep holding the debt.

Is the government simply delaying the inevitable? I’ve read a lot of opinions but haven’t seen compelling numbers & comprehensive analysis. This would be a cool modeling project if I was still at Lake…

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5 Responses to “Thoughts on subprime & the economy”


  1. 1 Chris Moran April 2, 2008 at 11:37 am

    Nice writing style. Looking forward to reading more from you.

    Chris Moran

  2. 2 joetaxpayerblog April 2, 2008 at 11:45 am

    “But, because there are tangible underlying assets (the land & the house), you can safely assume that once you lower the price enough, people will buy them.”

    Yes. If I am the lender and I hold a first mortgage on your home, lent with the guidelines that made sense (20% down), I can Say that even if the market dropped 30%, I’d recover most of my money.

    But – big but – mortgages got collateralized in a crazy way. Instead of buying a piece of this mortgage, all pieces being equal, they were combined and sliced into tranches that had different terms. The tranche that had the final payments as collateral is worthless. Imagine if, instead of having 1 loan for $100K on my house, I have ten loans for $10K each. Well, the first lien is pretty well guaranteed, right? But as you move up to where there’s no value to cover the note, that last piece of paper has no value at all. Make sense?
    Joe

  3. 3 Leo Chen April 2, 2008 at 12:05 pm

    Thanks Joe, makes perfect sense…

    That brings up another question. Which bonds & CDOs is the government actually insuring? I’d imagine there’s a good mix of low grade securities with high exposure in these “worthless” tranches which the government is also insuring. Which basically bails out these banks by allowing them to put an arbitrary value on these worthless, illiquid assets. Great use of taxpayer money!


  1. 1 Bad Debt » Blog Archive » Thoughts on subprime & the economy Trackback on April 2, 2008 at 11:43 am

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