Tuesday, March 27, 2007

Possible Impacts of the Subprime Sector on the US Economy

The subprime sector of the US housing market has weighed on equity markets and the economic outlook. This post assesses the possible impact.

- Ideally to calculate the possible impact one would utilize a series of detailed projections, taking into account the total amount of subprime and alt-a loans
and possible at risk loans. The best projection and discussion I've seen on possible subprime impacts is from http://www.loanperformance.com/infocenter/whitepaper/FARES_resets _whitepaper_021406.pdf (from First American Real Estate Solutions, which claims to be the number 1 source on real estate in the US, used by Moody's)

- FARES projects approximately $300Bn loans at risk over the next 5 years from interest rate resets, and, as losses will represent the loss on collateral, approximately $100Bn of total losses to the financial system, spread over 5 years.

- A weakness of the study is that only the loans made in 04 and 05 are represented, most likely significantly underrepresenting 06 and years before 03. (study completed in 2/06, but I haven't found anything of good quality newer) So one should increase the total at risk amount (unscientifically) by approximately 30-60% to account for the extra years.

- Another weakness of the study is that interest rate reset is at current interest rate levels -- all bets are off if interest rates rise significantly -- but
note that much higher interest rates are not extremely likely.

- Study assumes a level of 30% from the approximate $1 Trillion in loans that will reset at risk, which the author considers "conservative" -- and walks the
reader through his methodology. I would actually tend to agree as the average mortgage and other credit card interest payments to income is currently under 18.20%
(see http://www.federalreserve.gov/Releases/house debt/default.htm)
-- which indicates the average consumer in the US is NOT hurting by any means.

- All in all what is most interesting is that the total amount is manageable, as the total housing stock value is approximately $18-20 trillion, and value of outstanding loans are approximately $10 trillion (according to Moody's). The defaults and losses will be spread over at least 5 years, representing in total 3% of total mortgage value (number from the study, although more like 5% taking into account other years)and losses at 1% of total mortgage loan value.

- Also demographically the subprime sector tends to be inner city -- one study of subprime loans showed that 30-40% of the borrowers were African American. In California -- one of the largest subprime markets -- subprime loans are popular in the farming central area in addition to inner city. The defaults will hit the inner city harder and -- if I can venture out on this -- will also contribute to the increasing disparity trend in income distribution.

- The loans will likely default and be spread over several years, 5 or more, likely leading to a stagnant real estate market in the areas where subprime and
alt-a loans are popular. Perhaps a "two tiered" real estate market will develop --inner city and other lower income areas and middle to high income class


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