Last week, US Federal Reserve chairman Ben Bernanke told the US Congress he would support raising the limit on the size of the individual loans eligible for securitization by the government-sponsored mortgage finance entities from US$417,000 to $1 million, on a temporary basis.
He suggested that Fannie Mae and Freddie Mac could pay insurance premiums on these loans to the federal government, which would "act as guarantor" by taking on some of the credit risk.
Charles Schumer, the Democratic chairman of the Joint Economic Committee, enthusiastically welcomed the idea and said he would try to insert it into legislation already before Congress.
It came as Bernanke told Congress that estimates that set the total losses from subprime mortgages at about $150 billion were
probably "in the ballpark".
Given that the Fed and European Central Bank have already injected well over $150 billion since August, Bernanke obviously lied about his ballpark figure. But just how big is this subprime mess?
To measure subprime losses, we have to first find out the size of the subprime market. Fed data pegs the total US residential value at $20 trillion and the US residential mortgage market at $10 trillion. This number is substantial, as it eclipses the US treasury market of $9 trillion.
Of the $10 trillion mortgage market, government sponsored enterprises (GSEs) like Fannie and Freddie hold about $1.5 trillion, leaving $8.5 trillion in private hands. Within this $8.5 trillion, we have various grades and categories, with grades ranging from AAA, AA, Alt-A, BBB, and categories such as the traditional 30-year fixed, and non-traditional ARM, ARM with teaser rate, interest only, and negative-amortization.
The exact definition of subprime is not clear, with various sources estimating that the total subprime portfolio is between $1.5 trillion to $3 trillion. To precisely break down US$8.5 trillion by categories proves to be difficult. Nonetheless below is our estimate. We have valued the subprime market at $2 trillion. This is in line with an estimate by MSNBC reporter and research firm First American Loan Performance.
So just how much of the $2 trillion subprime position is lost? Various sources including First American Loan Performance estimated a default rate of 15%; this would translate to $300 billion of non-collectable principal and interest.
That in itself is not a big deal, as every year the United States spends well over $100 billion in Iraq and $400 billion on the military outside Iraq. The real concern is how such defaults are affecting the value of the existing outstanding subprime portfolio. In other words, would you eat beef knowing that one in 10 cows is a mad cow?
We follow the ABX index published by Markit.com, which is the basket of derivatives linked to subprime securities. As financial tools go, this index is far from perfect, since it is barely two years old, and tends to be thinly traded. But right now it has the unfortunate distinction of being the only tool easily available to measure sentiment in the opaque subprime securities world. And in the past couple of weeks, the message emerging from this measure has started to look utterly dire, as it shows subprime mortgages are changing hands at 25 cents on the dollar.
As we have shown in the pie chart above, this 80% haircut applies to potentially $2 trillion worth of mortgages if investors of those mortgages were to exit today. The loss is not $150 billion, but more like $1.6 trillion.
What's more, the ABX shows that since September 2007, the value of AAA mortgages has begun to crater, and now trades at a stunning 70 cents on the dollar. This means if all AAA and Alt-A mortgage portfolios were to be marked to market, the loss would amount to another $2 trillion.
Despite the fact that Bernanke and the Fed moved to a neutral balance of risks assessment last week, the market now sees a roughly 55% chance that the central bank will cut rates by another 50 basis points by the close of its January policy meeting, and an additional 15% chance that it will cut by 25 points by then.
And now you understand why Bernanke was so frantic in lowering interest rates and proposing the drastic policy measure of more than doubling the GSE limit to $1 million. In essence Bernanke is trying to increase the share of GSE in the pie and hopes the problem will go away.
The curious mind asks, who holds those trillions of dollars worth of mortgages? Thanks to the genius of the American banking and marketing machine, just about every sizable institution underneath the sun with a fixed income portfolio. From Europeans to Asians, from banks to brokerages, from hedge funds to pension funds, institution to retail, trusts to endowments.
Allow me to quote an FT.com article of November 1: