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The giant thing hiding in the closet

Monday, August 13, 2007

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.
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.


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

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

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Anonymous said...

Ben Stein isn't an economist! At least if his wikipedia page is to be believed ( the dude has a BA in economics and taught some securities law. Please. Yeah, I'm an "investment professional" because I'm halfway through an MBA.

Sounds to me like Ben wrote an article back in March, the Times sat on it for four months, then decided to publish it because he missed his deadline for this week.

Anonymous said...

I dont think Ben Stein is stupid. But I do think he is intentionally spreading lies to a gullible and dumb public, which makes him evil and weak. He is a paid disinformant.

Anonymous said...

I have an MBA, so I must be a CEO! Hey, COOL!

Maybe Ben ought to go back to letting people win his money - he was way more entertaining then. Or maybe he could help Bernanke drop money from the helicopters!

Anonymous said...

i'll bet it feels funny to those guys having joe retail mailing in their keys and leaving the banks and big money holding the bag for a change.

Anonymous said...

Can you show other asset prices on that chart? I'm curious to see what stocks look like over the same time period.

Anonymous said...

the way that stein rationalizes problems leads me to believe he is either a total idiot or a cheerleader for some group. no one could be as short sighted as this man......

Anonymous said...

Careful, that may have been Ben himself in the previous comment to yours!

Touch of class said...

You bears better hope that this latest market turmoil turns into a recession otherwise your arguments will start sounding a little long in the tooth. In your favor though, the cyclical nature of markets will eventually guarantee that economy enters a significant downturn.

Greenspan has been out of the fed for a while and its been even longer since interest rates were at 1%.

While individuals with bad credit have had an easy time of securing credit, developers have not. Therefore the number of speculative houses built are not as many as otherwise would be. In absolute terms there may be historically high numbers of unsold homes on the market. But I would think(but don't know) that relative to increasing population and shrinking household size unsold inventory is lower then during the real estate crash of the earl 90's.

Anonymous said...

So Ben Stein is a "paid disinformant"?

Anonymous said...

I think Ben's new motto should be "I'm not an economist, but I play one one TV".

His article demonstrates that he either has no concept of what is going on, or he is deliberately shilling for someone. His whole thesis is premised on the faulty assumption that only the money in the actually mortgages is actually at risk - he couldn't be more utterly wrong.

The real problem is that there are hundreds of trillions - yes trillion - in derivatives. The only way to get this type of money is to be heavily leveraged. The best example of this was LTCM that leverage a relively small 4 billion in actual cash into 1.2 trillion in derviatives!!!

This huge leverage in derivaties is the monster lurking in the closet - hell, it ain't in the closet, it sitting in the room in a rocking chair, rocking away, tapping its club on the floor while humming "Sympathy for the Devil" and everyone pretends it isn't there.

For soothe Ben Stein, you are smarter than that, and you should know better.

Anonymous said...

The size of the $34billion loss versus the $10.4 trillion arguement seems fair until the repo'd homes that get sold @ 50% of previous best values. Then you have effectively, re-valued the entire real estate market down by 50% too.
That means we would have effectively lost $5.2 trillion dollars out of the economy.. & That Ben Stein is a tidy sum, even with my bank account.

Anonymous said...

Ben talks about 5% of subprime borrowers in foreclosure. I’m sure he ran out of room in his column to give us an update on all that inventory already foreclosed and sitting on the banks’ balance sheets -- green pools included. See for example .

I don’t think Ben has been paying much attention to all the trouble in Alt-A land or even Countrywide’s statement that its prime loan delinquencies were 4.6% up from 1.8% a year earlier (must be statistically insignificant to an *cough* economist).

I wish he had the space in his column to explain how good it is for the economy to have people who are paying on time watch their home equity declining on two fronts: price declines and negative amortization.

Chicken Little

Bridget Magnus said...

I read the Stein article over the weekend and decided (again) that he is an idiot. Apparently he never heard the saying about how "If you are calm when everyone around you is in a panic, you clearly don't understand the situation."

His argument, in short, that "5% of 14% of 13% is not a big deal so everybody must be overreacting" not only ignores derivatives, it assumes that the worst things could possibly get is "perhaps it will double."

That of course assumes that the other 95% of the 14% in delinquency will magically find ways to pay the mortgage, that the other 86% of sub-prime mortgage holders will not become delinquent, and that there is no risk whatsoever of delinquency/foreclosure in the 87% of non-subprime mortgages. It assume there are no other companies so levered to sub-prime that they risk going out of business and throwing thousands of people out of work. It furthermore assumes that there will be no collateral fall-out as people are unable to refinance or take out home equity to pay other debts, send a child to college, or start a business.

In short, it assumes that other than sofa being on fire, everything is fine. Nothing to see here, move along. I am not saying the sky is falling, but I am saying we should monitor it closely before deciding what is going on.

Anonymous said...

Ben's simple arithmetic is akin to saying that the hole in the dam is actually a very small portion of the dam.

As other posters have said, the derivatives "weapons of mass financial destruction" should be a concern, not to mention the myriad problems that subprime mortgage are an indicator of or the myriad problems that they will cause.

Ben, you might not be as smart as you think.

Think about it: mortgage would be a great hangman word.

repo4sale said...

$70 Trillion = Total Wealth in USA -12 Trillion (real estate fake value) -12 Trillion (Fake Subprime Bonds!) -12 Trillion (Related Markets Losses) =$34 Trillion New USA Wealth!(50%off)

Cash then doubles in value! (HA!)

Been selling 2002 to 2007!
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Tim said...

Here's a comment that showed up at the Seeking Alpha version of this post:

Tim, not sure what bothers me more, your desire to shoot economists or your citing the Pimco Plankton theory. I don't like referring to first time homeowners as plankton, and your notion of plankton's financial ecosystem leaves out the fact that plankton are food for whales (who would that be in the plankton metaphor?). I am curious why you chastise the mortgage lenders and yet omit those who used mortgage debt for collateral on other complex derivatives with huge leverage. Regarding Ben Stein, his NY Times article was a valid approximation of near-term mortgage issues, albeit an invalid application of the calculation to the real liquidity problems.

Look Tim, the problem is that investment banks tried to circumvent the Federal Reserve. They basically used mortgage debt and leverage to create a potential credit arsenal equivalent to central banks. And then they waged war on the Fed, in the sense that they could loosen credit using leverage, without the Fed having to lower interest rates and without any regulatory restrictions on their activity (hmm plankton?). It was a bold and stupid move, and because it seemed to work for a while they were emboldened to the point of folly. And it is folly for anyone to chime in for the Fed to bail them out by easing interest rates.

But Tim, don't kid yourself, or anyone else, this crisis is fundamentally about how investment banks and hedge funds tried to set their own easy money monetary policy. Of course the Fed will get blamed for the resulting inflationary pressures that the investment bank's easy money policy created, but that is how financial politics works today (blame the government). Its amazing to me that after the mess investment banks made when they threw away hundreds of billions of dollars in smoke and mirrors, which Greenspan helped clean up, you blame him for the problem.

On the positive side however, a large part of the investments made with this cheap credit will now blossom to grow the economy, but there is no doubt that the effects of reckless lending leveraged from mortgage debt will sting for a while.

I don't know quite what to make of it - clearly he likes using my name.

graphrix said...

I posted the comment below here

I went Cramer on Ben's comments as he has no idea, none.

Here are some scary numbers to prove him wrong.

I looked at 20 of 40 Countrywide's subprime MBS deals of 2006. These have an average FICO score of 610. Of the $18.1 billion current balance 9.23% $1.67 billion is in foreclosure, BK or REO. That is just one lender and half of what they did in 2006.

Impac an ALT-A lender just released their 2-Q numbers. They currently have $358 million in REO which they adjusted the value lower by $26 million. Add that to the loans currently 60 days late or greater and it is over $2 billion.

Here in Orange County CA if you take the last 6 months of foreclosures and the NODs from the 6 months previous to that the coversion ratio is 40%. The last 6 months of NODs total nearly 6000 which means OC at the 40% ratio will have another 2400 foreclosures in the next 6 months. At the end of the year that would mean over 3400 foreclosures and with an avergage $500k loan amount that is over $2 billion. How much of that is subprime or ALT-A? I bet well over 50%.

The worst part is it is not getting any better. So Ben needs to wake up and realize $67 billion in California alone is more like it.


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