The giant thing hiding in the closet

Ben Stein's "Chicken Little" article in yesterday's New York Times is another reason why the world, collectively, should give serious thought to taking about two-thirds (maybe more like seven-eighths) of all economists out back and shooting them.

THE job of an economist, among many other duties, is to put things into perspective. So, because I am an economist, among other duties, here is a little perspective on the recent turmoil in the stock and bond markets.

First, when the story of this turbulence is reported, the usual explanation mainly has to do with some new loss in the subprime mortgage world — the universe of mortgages and mortgage-backed instruments related to buyers with poor credit histories or none at all.

Here is the first instance in which proportion tells us that something is out of whack:

The total mortgage market in the United States is roughly $10.4 trillion. Of that, a little over 13 percent, or about $1.35 trillion, is subprime — certainly a large sum. Of this, nearly 14 percent is delinquent, meaning late in payment or in foreclosure. Of this amount, about 5 percent is actually in foreclosure, or about $67 billion. Of this amount, according to my friends in real estate, at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion.

The rate of loss in subprime mortgages keeps climbing. In time, perhaps it will double, maybe back to $67 billion. This is a large sum by absolute standards, and I would sure like to have it in my bank account.

But by the metrics of a large economy, it is nothing. The total wealth of the United States is about $70 trillion.
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MY point is this: I don’t know where the bottom is on subprime. I don’t know how bad the problems are at Bear. Yet I do know that the market reactions are wildly out of proportion to the real problems that have been revealed. Maybe there is some giant thing hiding in the closet that might rationalize the market’s fears. But if it’s hidden, how can the market be reacting to it in the first place?

Well, Ben, here's a little more perspective - maybe that giant thing hiding in the closet can be found if we look at things in a different way.

According to the latest Federal Reserve Z1 report, the total value of owner-occupied housing is about $23 trillion. As shown in the chart below, the total is up considerably from just a few years ago as indicated in blue, however, the curve looks like it's beginning to flatten - keep an eye on that.

How did prices get so high in recent years? Well, that has a lot to do with who's been buying houses in recent years, setting prices "at the margin" as they say.


Who's been setting a lot of these prices at the margin?

Subprime borrowers.

They've been pushing home prices up from the bottom, paying more for starter homes, enabling more typical homeowners to cash out and trade up and so on, until home prices in your neighborhood are affected too.

Over at Pimco, they call them Plankton.

If it turns out that people have been paying way too much for real estate in recent years because money has been so cheap and lenders so lax (it's looking more likely every day), markets will revert to the mean and there could be hell to pay.

A 10 percent drop from that $23 trillion total would be a loss of $2.3 trillion in national real estate wealth - a 20 percent decline would result in almost a $5 trillion hit.

That's a lot less home equity withdrawal and a lot fewer reverse mortgages - consumer spending and ultimately the broader economy will suffer. Maybe a lot.

These are big numbers - this is the giant thing hiding in the closet.

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UPDATE: 8/14/07, 6:00 AM

The chart below along with a bit more commentary appears in the next post: