Putting the subprime problem in context
The interesting commentary that follows (alas, sans the mentioned charts) is by Scott Grannis, Chief Economist at Western Asset Management.
-- David M Gordon / The Deipnosophist
================================
Subprime jitters have put everyone on edge these days, mainly because it's difficult to project the extent of the fallout from what amounts to a credit squeeze that is impacting potentially millions of homeowners, borrowers and investors. Delinquency rates on subprime loans could be as high as 15%, and default rates are rising. Subprime and Alt A mortgages accounted for about 40% of total mortgage originations last year, according to Wachovia Bank.
Will the foreclosures that result from existing subprime borrowers going belly up, coupled with the shutting off of credit to new subprime borrowers, have a significant impact on the overall housing market? Will subtracting a million or so marginal homebuyers from the market have a significant impact on the overall demand for housing, causing housing starts to tumble further and prices to fall further than they already have or would have fallen? Can the subprime tail wag the big dog that is the U.S. economy?
So far the numbers don't look too scary. According to Morgan Stanley, there are just over $600 billion of securitized subprime mortgages outstanding, which probably equates to some 2 or perhaps 3 million subprime borrowers. Even if subprime defaults eventually resulted in as much as $300 billion in losses (the very high end of estimates I have seen), that is only about 2% of the $15.7 trillion liquid portion of the U.S. bond market, and less than 1% of the $33 trillion liquid portion of the global bond market (surely foreign holdings of subprime mortgages are a not inconsiderable part of the total). It's only 1.3% of the value of the U.S. housing market. Furthermore, it only represents 0.5% of the $55.6 trillion net worth of U.S. households, and only 0.7% of the $42.1 trillion of financial assets held by U.S. households, according to the Federal Reserve. $300 billion sounds like a lot, but it's only a drop in the liquidity bucket. Shutting off subprime lending altogether might mean a reduction in the number of homebuyers equal to 1-2% of the nation's 135 million households, but that's hardly enough to push housing prices off a cliff.
Based on the numbers, the subprime lending problem looks rather minor. From a broader perspective, the contagion potential of the subprime crisis has a lot to do with the general health of both the economy and the financial markets. When I survey some of the key indicators of economic and financial health, I am greatly reassurred. We're facing a problem, but it is far from insurmountable.
Implied volatility in stock and bond options is a good proxy for systemic risk and fear. As the first chart shows, implied volatility is still relatively low from an historical perspective. We've seen conditions that were far worse than those we face today, and for sustained periods, without disaster striking. The second chart shows that the recent drop in the stock market is still very minor. The rise in equity volatility we've seen recently is far from the sort that accompanies major market downturns. Fear is maximized when prices fall significantly, and we just haven't seen any of that so far. I note that an index of homebuilders' equity is 16% above its lows of last summer, despite a steady drumbeat of negative housing-related news.
Swap spreads are a good proxy for systemic risk, liquidity, and the willingness of investors to take on risk. Swap spreads were tighter in the mid-1990s than they are today, but they are far from the levels associated with past economic and financial crises (e.g., recessions and the corporate defaults of the early 2000s). Credit spreads in general are relatively tight, and spreads in the riskiest sectors of the bond market are exceptionally tight, suggesting there has been essentially no contagion from the housing market to date. Spreads have indeed widened as fears over subprime loans have mounted, but you can hardly see the widening from an historical perspective.
If the subprime lending crisis is essentially a credit crunch (Freddie Mac, which has typically purchased some 20% of the AAA tranches of subprime loans, will soon cease its purchases of such, numerous issuers of subprime mortgages have either gone out of business or announced they will no longer make these kinds of loans, and regulators have urged much tighter lending standards for those who do remain in the business), will this combine with an existing credit squeeze to strangle the economy? Surveying the principal indicators of the availability of liquidity suggests that there is no shortage of liquidity, and no squeeze apparent anywhere outside the subprime market.
To begin with, the next chart shows that while new applications for mortgages are down some 25% from their 2005 highs, the pace of new lending is still much higher than it was in the booming 1990s, and it hasn't fallen at all relative to the levels of last summer, despite the drying up of subprime lending which began earlier this year. Meanwhile, mortgage rates are still quite low relative to the levels of the not-too-distant past.
The dollar is near the low end of its historical range relative to other major currencies, strong evidence that there is no shortage of dollars in the world.
The Fed has tightened policy relative to where it was a few years ago, but from an historical perspective, monetary policy is still far from reaching the level of "tightness" that provoked past recessions. Fed governors are uneasy with inflation running somewhat above their comfort zone, but with the economy soft and housing questionable they are quite unlikely to take any further tightening measures, at least for the next several months. Indeed, the bond market expects that an easing of policy is far more likely than a tightening.
Gold prices in the past have typically played the role of "canary in the coalmine" when it comes to monetary policy. Gold tends to rise relative to other prices when money is easy and inflationary pressures are rising, and gold tends to fall relative to other prices when money is tight and inflation pressures are declining. Gold at $645/oz. today suggests at the very least that liquidity is more abundant than it has been on average in the past 30 years.
With the exception of energy prices, which are off their highs but still historically elevated, industrial commodity prices continue to move to new high ground. As with gold, this could reflect relatively abundant liquidity conditions, but it also reflects a robust global economy. Industrial production in the U.S. has been stagnant since last summer, but global manufacturing activity has never been stronger. The U.S. has traditionally been the world economy's locomotive, but these days the rest of the world is helping to keep us moving forward.
Tight liquidity is often reflected in bond yields that are high relative to inflation. As the next chart shows, today's real yields are below their long-term average, and well below the levels that have prevailed for most of the past 25 years, suggesting again an absence of any general liquidity squeeze.
The outlook for defaults and distressed home sales would certainly be aggravated by a deteriorating labor market, but so far the worst that can be said is that jobs are growing at a slower rate today (1.4%) than a year ago (2.5%). Despite slower jobs growth, the unemployment rate today is a relatively low 4.5% and has rarely been lower. Weekly unemployment claims have moved up a bit in recent weeks, but this could be due to the effects of bad weather; this is certainly an important indicator to watch on the margin, but so far it is still relatively benign.
Adding it all up, I would venture to say that the subprime mortgage problem is a crisis that has relatively short legs. The U.S. economy is reasonably healthy, financial markets exhibit little or no sign of spreading distress, and liquidity is deep and relatively abundant.
-- David M Gordon / The Deipnosophist
================================
Subprime jitters have put everyone on edge these days, mainly because it's difficult to project the extent of the fallout from what amounts to a credit squeeze that is impacting potentially millions of homeowners, borrowers and investors. Delinquency rates on subprime loans could be as high as 15%, and default rates are rising. Subprime and Alt A mortgages accounted for about 40% of total mortgage originations last year, according to Wachovia Bank.
Will the foreclosures that result from existing subprime borrowers going belly up, coupled with the shutting off of credit to new subprime borrowers, have a significant impact on the overall housing market? Will subtracting a million or so marginal homebuyers from the market have a significant impact on the overall demand for housing, causing housing starts to tumble further and prices to fall further than they already have or would have fallen? Can the subprime tail wag the big dog that is the U.S. economy?
So far the numbers don't look too scary. According to Morgan Stanley, there are just over $600 billion of securitized subprime mortgages outstanding, which probably equates to some 2 or perhaps 3 million subprime borrowers. Even if subprime defaults eventually resulted in as much as $300 billion in losses (the very high end of estimates I have seen), that is only about 2% of the $15.7 trillion liquid portion of the U.S. bond market, and less than 1% of the $33 trillion liquid portion of the global bond market (surely foreign holdings of subprime mortgages are a not inconsiderable part of the total). It's only 1.3% of the value of the U.S. housing market. Furthermore, it only represents 0.5% of the $55.6 trillion net worth of U.S. households, and only 0.7% of the $42.1 trillion of financial assets held by U.S. households, according to the Federal Reserve. $300 billion sounds like a lot, but it's only a drop in the liquidity bucket. Shutting off subprime lending altogether might mean a reduction in the number of homebuyers equal to 1-2% of the nation's 135 million households, but that's hardly enough to push housing prices off a cliff.
Based on the numbers, the subprime lending problem looks rather minor. From a broader perspective, the contagion potential of the subprime crisis has a lot to do with the general health of both the economy and the financial markets. When I survey some of the key indicators of economic and financial health, I am greatly reassurred. We're facing a problem, but it is far from insurmountable.
Implied volatility in stock and bond options is a good proxy for systemic risk and fear. As the first chart shows, implied volatility is still relatively low from an historical perspective. We've seen conditions that were far worse than those we face today, and for sustained periods, without disaster striking. The second chart shows that the recent drop in the stock market is still very minor. The rise in equity volatility we've seen recently is far from the sort that accompanies major market downturns. Fear is maximized when prices fall significantly, and we just haven't seen any of that so far. I note that an index of homebuilders' equity is 16% above its lows of last summer, despite a steady drumbeat of negative housing-related news.
Swap spreads are a good proxy for systemic risk, liquidity, and the willingness of investors to take on risk. Swap spreads were tighter in the mid-1990s than they are today, but they are far from the levels associated with past economic and financial crises (e.g., recessions and the corporate defaults of the early 2000s). Credit spreads in general are relatively tight, and spreads in the riskiest sectors of the bond market are exceptionally tight, suggesting there has been essentially no contagion from the housing market to date. Spreads have indeed widened as fears over subprime loans have mounted, but you can hardly see the widening from an historical perspective.
If the subprime lending crisis is essentially a credit crunch (Freddie Mac, which has typically purchased some 20% of the AAA tranches of subprime loans, will soon cease its purchases of such, numerous issuers of subprime mortgages have either gone out of business or announced they will no longer make these kinds of loans, and regulators have urged much tighter lending standards for those who do remain in the business), will this combine with an existing credit squeeze to strangle the economy? Surveying the principal indicators of the availability of liquidity suggests that there is no shortage of liquidity, and no squeeze apparent anywhere outside the subprime market.
To begin with, the next chart shows that while new applications for mortgages are down some 25% from their 2005 highs, the pace of new lending is still much higher than it was in the booming 1990s, and it hasn't fallen at all relative to the levels of last summer, despite the drying up of subprime lending which began earlier this year. Meanwhile, mortgage rates are still quite low relative to the levels of the not-too-distant past.
The dollar is near the low end of its historical range relative to other major currencies, strong evidence that there is no shortage of dollars in the world.
The Fed has tightened policy relative to where it was a few years ago, but from an historical perspective, monetary policy is still far from reaching the level of "tightness" that provoked past recessions. Fed governors are uneasy with inflation running somewhat above their comfort zone, but with the economy soft and housing questionable they are quite unlikely to take any further tightening measures, at least for the next several months. Indeed, the bond market expects that an easing of policy is far more likely than a tightening.
Gold prices in the past have typically played the role of "canary in the coalmine" when it comes to monetary policy. Gold tends to rise relative to other prices when money is easy and inflationary pressures are rising, and gold tends to fall relative to other prices when money is tight and inflation pressures are declining. Gold at $645/oz. today suggests at the very least that liquidity is more abundant than it has been on average in the past 30 years.
With the exception of energy prices, which are off their highs but still historically elevated, industrial commodity prices continue to move to new high ground. As with gold, this could reflect relatively abundant liquidity conditions, but it also reflects a robust global economy. Industrial production in the U.S. has been stagnant since last summer, but global manufacturing activity has never been stronger. The U.S. has traditionally been the world economy's locomotive, but these days the rest of the world is helping to keep us moving forward.
Tight liquidity is often reflected in bond yields that are high relative to inflation. As the next chart shows, today's real yields are below their long-term average, and well below the levels that have prevailed for most of the past 25 years, suggesting again an absence of any general liquidity squeeze.
The outlook for defaults and distressed home sales would certainly be aggravated by a deteriorating labor market, but so far the worst that can be said is that jobs are growing at a slower rate today (1.4%) than a year ago (2.5%). Despite slower jobs growth, the unemployment rate today is a relatively low 4.5% and has rarely been lower. Weekly unemployment claims have moved up a bit in recent weeks, but this could be due to the effects of bad weather; this is certainly an important indicator to watch on the margin, but so far it is still relatively benign.
Adding it all up, I would venture to say that the subprime mortgage problem is a crisis that has relatively short legs. The U.S. economy is reasonably healthy, financial markets exhibit little or no sign of spreading distress, and liquidity is deep and relatively abundant.
Labels: Economics
posted by David M Gordon | 7:52 PM
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