Monday, November 19, 2007

How Many Foreclosures Fit on the Head of a Writedown?

by Ken Houghton

UPDATE: Yves Smith at Naked Capitalism corrects some of my data errors and delves a bit deeper. (See also Tom's comment.)

With the help of the now-free-if-you-Digg-It (h/t Felix) WSJ, let us see if we can rationalize some numbers.

There is a projection of 2 million (2E6) foreclosures (corrected, thank you Anonymous here) in the mortgage market over the next few years. Since most of those seem to be described as "subprime," it is reasonable to assume that they will mostly be non-Jumbo, Fannie/Freddie-eligible mortgages. That currently means their value (of the mortgage that is, not the house) is capped at $417,000. (4.17E5).

Now 4.17 x 2 = 8.34, so we are talking—absolute worst case—$8.34E11, or $834 billion. And that's if the home and the land are all worth zero, everyone took a maximum mortgage, and all two million foreclosures (corrected; see above) happen. Over the next several years.

I think we can agree that the above should be the worst-case scenario. (Even if the properties are all on Lon Gisland, that should still leave at least 50% of the value intact.)

Now, it's entirely possible that the WSJ and I have missed a few firms. But I believe most of the large ones, including Swiss Re today (h/t Calculated Risk) are represented below:

By my (and Excel's) math, assuming the Absolute Worst Case Scenario being Discussed, just under 7.8% of the Total Possible Value of the pending foreclosures (ibid.) has already been written off.

Now, I'll readily concede that some of those writeoffs may have been excessive, though Tanta makes the reasonable case (while b*tch-sl*pp*ng a deserving Peter Eavis) that there isn't much of a range of GAAP options. Some, though, may have just been the tip of the iceberg. (FYI, I have tried to keep CDO/CDS writeoffs out of the calculations.) So if we start restricting the model (assume that not all loans were for the maximum amount, or that there is residual value in the property and/or loan after foreclosure), that just-under-8% starts looking more and more as if a large share of the losses are already accounted for, with the worst yet to come.

(Please, those of you who are solvent, hit the Calculated Risk tip jar.)

So the most reasonable assumption (Entia non sunt multiplicanda praeter necessitatem) is that one of the inputs to the model is incorrect.

Note that the "model" has only two inputs to reach that $834B maximum:

  1. The maximum amount a GSE such as Fannie covered since 2006 is certain, and it was never higher than that for Single-Family mortgages.

  2. So that leaves the 2,000,000 expected housing foreclosures in the next few years. If you think the worst is yet to come, and you expect that the write-downs are not going to cover the entirety of the problem (some of those MBSes are stuffed into Jim Hamilton's pension fund (link added), for instance—and probably yours and mine, too), then this is the likely candidate for change.

If we believe what the banks are doing, and not what they may be saying, then that Goldman Sachs projection about the effect on collateral securities such as CDOs may look optimistic.

Unless I'm missing something, which is entirely possible. Anyone?

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I took the liberty of analyzing your post over at Naked Captialism. I would have done it via a comment here except, as you will see, it wound up being pretty lengthy, plus I thought it would interet my readers.

It was a worthwhile undertaking but I had some issues with it. If I misinterpreted what you wrote, don't hesitate to let me know.


Yves, thanks for leaving the comment.

The point that the bag-holders include entities other than securities firms is a good one, but Ken allows that via the perhaps slightly cryptic remark about Jim Hamilton's pension plan.

As far as an amount that I might agree to over drinks as the maximum scope of the mortgage problem, something approaching $1T seems reasonable enough. I'd expect that sometime before we were too hypothetically drunk, I would object that he omitted subprime modifications and prime everything (a reasonable critique of the "model"), to which he'd probably say that the $417K-per-adverse-event figure covers those in principle. None of this is to say that it wouldn't be desirable to have separate and more finely tuned prime and subprime inputs for the fundamentals.

As for the vagaries of the market and marking to it, that's a good point too; it's reasonable enough to describe that as having an unknown effect.

In the end, having something that looks like a ceiling but isn't a supremum leaves me feeling underinformed. It seems that the amounts written off are large, but it hasn't been established whether the worst is over or is yet to come.

(Substantially identical comment also left at Naked Capitalism.)
As a bankruptcy attorney, I can say with absolute certainty that bankruptcy need not result in foreclosure, and may actually prevent it. Conversely, in a non-recourse state, foreclosure need not result in bankruptcy.
I think "bankruptcies" should read "foreclosures." Ken?
Corrected throughout.
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