Math of Subprime Mortgage Default

This article tentatively accepts the proposition that the default of sub prime mortgages and the subsequent decline of housing prices have been the cause of critical problems in the banking system and collapse of credit markets world wide.

Letís do some housing math.  Last fall there were about one million delinquent mortgages.  Let us presume the current figure is now fifty percent worse ñ i.e. one point five million homes.

Assume that the average delinquent loan has a face value of about $180,000, and that a typical mortgage would have a term of from 15 to 30 years to maturity.  Under normal circumstances the borrower would be required to pay about $10,800 per year in interest and principal to amortize the loan.  Because of the variable rate mortgages this cost would be about $20000 per year per loan.

We are told that the housing crises is the cause of the current financial problems of the banking industry and  that fixing the housing crises is a critical first step in restoring financial stability to the economy. On a worst case basis presume that all delinquent mortgages are in default, which is not true because some of the borrowers could make partial payments or could pay if the terms of the mortgages were renegotiated.

The annual cost of the delinquent payments would be $30 billion.  Are we to believe that for a cost of less than $2.5 billion per month all of the defaults of all of the banks on all of the sub prime mortgages could be resolved?

Why then are we talking about payments to banks and financial institutions of more than a trillion dollars? Is there no one in Washington that does the math? Wait, you say, the problem is more difficult. You are right, other complications must be considered.

If the Federal government, on a temporary basis, guaranteed the monthly payments of the mortgages that are delinquent, the banks would have no reason to presume, as they do, that the outstanding balance of the loan is in default.  When banks make this presumption they deduct the total value of the loan from their reserves.  They declare this amount to be a loss which impacts their capital account. The formal declaration of loan default triggers a secondary default of derivative securities for which the sub prime mortgages are collateral. This in turn activates the credit default swaps obligations.

Housing market foreclosure proceedings and the subsequent sale of assets by public auction creates an environment of pure opportunism in which there is no floor price.  The structure of the market encourages instability and low pricing.  This procedure obviously has a negative affect on the whole real estate market.

With respect to renegotiation of troubled mortgages the method of evaluation of property is important.  In a stable, unemotional market the value of a home would be the replacement cost plus the value of the land.  Both factors can be reasonably determined by skilled evaluation. In some instances the land could, in fact, have only nominal value.  In any normal market the value thus determined should represent the minimum basic price at which a house would be sold and also the value for mortgage purposes.

Let us take a typical sub prime home with a 10 year variable rate loan, now at 11%, in the amount of $200,000 which is now under water by $50,000.  The ownerís monthly cost is $2507 per month.   If the calculated assessed value determined by the procedure proposed above is $170,000, a new 30 year fixed rate mortgage at 6% would cost $1049 per month.  The bank would now have a non toxic asset on its books equal to 85% of the original loan value. It is only the remaining 15% that is toxic.

What would be the cost of settling all 1500000 delinquent mortgages, using the same assumptions?   The total amount owing would be $255 billion which would convert into $217 billion of credit worthy loans and toxic assets of $38.25 billion.  Even in a worst case analysis this is the cost of stopping the housing slump, refinancing the banking system and restoring the credit markets to normality.  In total it represents only a few days of normal Federal Government spending.

A matter of great complexity would be the renegotiation of the terms of outstanding credit obligations so that the principal would be secure but the rates of return would be reduced. It took Canada many months to negotiate an arrangement to prevent the default of collateralized debt obligations.

So, maybe my calculations are a bit off.  Suppose the number of homes to be refinanced is double the amount calculated.  Suppose other uncertainties of equal magnitude exist. Nothing adds up to the trillions of dollars spent and proposed to be spent. The magnitude of these expenditures must inevitably lead to the deterioration of the US dollar as a currency.  And, if a significant portion of leveraged debt can be saved, AIG might not need more bail out money.

At this time, with unemployment of 8%, most wage earners are better off than they were a year ago  Oil and gas prices are down, clothing prices are at sale levels.  Cars are being sold at much reduced prices (5 years at 0% interest), housing prices will never again be as low as they are. It would cost only $100 billion per year to double unemployment benefits for the unemployed. Investors, and particularly retirees, have suffered greatly.  With stock prices at enticing fifteen year lows there is hope of some recovery but perhaps something should be done for them as well.

Would someone please kindly explain to me how my calculations can be so wrong! CNN has suggested that the cost of the recovery program proposed to date will be in excess of $2,4 trillion. Is there no one in Washington that can do simple math or is there some rule that rounds off any calculation to the nearest eleven zero figure.

John E. Conner

John Conner is a former Royal Canadian Air Force pilot, an economist and he’s founded and headed a company or two. He’s now retired and free to pour a shot at the Whiskey Bar now and then.