Comments on: U.S. Subprime Mortgage Market Meltdown by James Barth

1. Comments on:U.S. Subprime Mortgage Market MeltdownbyJames Barth Randall K Filer CERGE-EI and CUNY

2. Sometimes We Act As If Falling Prices Are a Crisis

3. But Sometimes They’re A Good Thing

4. And SometimesWe Aren’t Sure

5. Think of a Market With • Rapidly Falling Prices • Accumulating Unsold Inventories • Many Owners with Negative Equity

6. I-Phone Market Meltdown! YESIt’s the Dreaded

7. The Housing/Subprime Problem Look at it from three perspectives: • Homeowners • Investors in Mortgage-Backed Securities • The Financial System

8. Homeowners Start with Banjari, Lanier and Krainer, Journal of Urban Economics, 2005 • Welfare Effects of Housing Price Changes = 0 • Basic Insight, for every seller there is a buyer • And these offset each other

9. In Reality – Distribution Effects Owner House Price Randy 1,000,000 HK Oleh 800,000 HK Ricardo 600,000 HK Boris 400,000 HK

10. Now, Randy Meets His Maker and Everyone Moves Up the Ladder House Price Change in Cash Randy’s Heirs 0 HK +1,000,000 HK Oleh 1,000,000 HK - 200,000 HK Ricardo 800,000 HK - 200,000 HK Boris 600,000 HK - 200,000 HK Tomislav 400,000 HK - 400,000 HK SUM 0 HK

11. Suppose House Prices Have Fallen By 50% House Price Change in Cash Randy’s Heirs 0 HK + 500,000 HK Oleh 500,000 HK - 100,000 HK Ricardo 400,000 HK - 100,000 HK Boris 300,000 HK - 100,000 HK Tomislav 200,000 HK - 200,000 HK SUM 0 HK

12. Comparison Net Change in Cash Positions is Still Zero BUT 4 of the 5 participants are BETTER OFF ONLY One is WORSE OFF

13. In General • Losers from Housing Price Decreases • Those who take cash out on sale • Typically heirs of deceased or elderly downsizing and planning on using assets for retirement • Also Credit Constrained who want to use housing equity as collateral for other purposes (e.g. business start-ups)

14. Gainers from Housing Price Declines • Anyone who is putting cash INTO a transaction • Families trading up to larger houses • First time home buyers • Also lateral movers due to factors such as job changes (transaction costs are lower)

15. On Balance FAR MORE GAINERS THAN LOSERS GAINERS ARE LIKELY TO HAVE LOWER INCOMES

16. What About Negative Equity? For MOST units no problem They were purchased to deliver a certain amount of housing services at a certain price Neither of these have changed, why would occupant renege? Especially since reputation effect would preclude obtaining a new unit

17. Price Decline would make it cheaper to trade up, but for this it does not matter if cash is used to retire negative equity or obtain new house If you think about it, almost EVERY new car bought on credit has a period when value is less than outstanding loan but nobody cares

18. Could Be a Barrier to Mobility Negative equity might inhibit mobility if occupant lacks cash to pay off mortgage when opportunity arises in a new area Easy Solution – Attach mortgages to individual not property and allow transfer so long as new collateral is at least as great as old

19. Investors in Mortgage-Backed Securities There has not been much, if any meaningful analysis. Current market prices are uninformative Real question is risk and return on portfolio of assets if held to maturity

20. Thought Experiment Imagine buying two assets: • Diversified portfolio of Subprime Mortgages • Mutual Fund of Junk-Rated Corporate Bonds Hold each for 10 years

21. Which Portfolio Would Have Higher Yield Over 10-Year Period? Remember, 10-year cumulative default probability on B-rated bonds is 43% Do we really believe the default rate on even subprime mortgages will be that high? Center for Responsible Lending projects cumulative foreclosure rate for subprime mortgages issued in 2006 at 19%. Even sensitivity analyses with extreme assumptions have a hard time getting foreclosure rate as high as 40% And, repossessed houses will have a much higher recover rate than defaulted bonds

22. Conclusion • There is not now, nor is there likely to be, evidence that investors in subprime mortgage backed securities who hold to maturity will receive abnormally low returns • Those who sell while the market is distressed may take a haircut but this will be offset by excess returns for the buyers

23. Financial Markets • HERE IS THE REAL PROBLEM • LIQUIDITY IN GENERAL HAS DRIED UP • CREATES TWO MAJOR DANGERS: 1) Lack of landing affects the real economy – investment and/or consumption collapse 2) FED feels it must inject liquidity, igniting inflation or causing “rolling asset bubbles”

24. Causal Change? Dot Com Bubble Bust → Low Interest Rates → Housing Bubble, Housing Bubble Bust → Low Interest Rates → Weak Dollar & Commodity Market Bubble??

25. The “Problem” Is Almost Entirely Artificial • At the moment there is almost no “market” in mortgage-backed paper. • This has led to a excessive price collapse when compared to fundamentals • OECD estimate is that to justify current prices, recovery rate on foreclosed properties would have to be NO GREATER than ZERO

26. Regulatory Failure • “Mark-to-Market rules force institutions to value these holdings at their totally unrealistic trading prices • This reduces’ institutions capital and loanable funds • In large part these reported losses are paper losses that will be restored to the books when the real assets underlying the securities are sold, even at depressed prices

27. Result Creates Real Economic Damage from Unreal Paper Losses. Solution: Mark-to-Market must be suspended when no effective market exists Allow Mark-to-Model or Fraction of Book. Paul Craig Roberts suggests 85-90%. I might be more conservative, but even 60-75% would recapitalize without dangerous injections

28. As Always, Marx Understood the Problem “[In Florida] you can get any kind of house you want.” “You can even get stucco.” “Boy, can you get stucco!” Groucho Marx, Cocoanuts, 1929