The Wall Street Journal lead in its April 4-6th edition, is about the subprime crisis, and it reveals some interesting statistics. The Federal Housing Administration had been intended to assist moderate-income earning people to buy a home by requiring of them a mere 3% downpayment. However sub-prime lenders took over most of this sector, predominantly from Q1 2005, by requiring a 0% downpayment, creating a new class of borrowers who had nothing to lose. In 2007 FHA 3% downpayment loans enjoyed a decline in foreclosures, while subprime losses soared. The notion that sub-prime borrowers cannot afford their monthly payments, however is negated by another statistic from the Boston Federal Reserve which shows that
homeowners who’ve suffered a 20% decline in home prices are 14 times as likely to default as those who have enjoyed a 20% gain.
Because the subprime borrowers have nothing to lose, they can simply walk away from their mortgage, when the property price pushes them into a capital loss, leaving all the losses with the lender. It is interesting that even a 3% downpayment is enough to stop the walk-away effect which is now crippling the 0% sector.
In amidst the sub-prime gloom, it is easy to forget that not all Americans are directly affected. The Mortgage Bankers Association tracks 46 million mortgage borrowers, and they declare that 42 million mortgages are still being paid on time. Only 4 million are in potential default at the moment. That number should be added to the 1,000,000 or 1,250,000 who have already been foreclosed, giving a maybe 5,000,000 or so total problem to deal with. The problem for the banks is that the property price could still have quite a bit more to fall, and the numbers motivated to walk or default would accelerate.
The problem of foreclosure could affect up to 10,000,000 homes in the end of the day, if the worst forecasts are realised. That said, more than 20 million homes are owned outright with no borrowing, and 35 million houses are rented, giving the USA almost exactly 100 million households total.
Measures now being considered by Congress are aimed at stopping the subprime crisis ratcheting into a deeper spiral of falling prices triggering further walkaway foreclosures, pushing the losses from the level already pencilled in by banks like Lehman Bros who have been quoting $400 billion towards the much more devastating figure of $1 trillion. The banks have been just about able to cope with the scale of the collapse so far but only with fairly inelegant measures such as the rushed J.P.Morgan takeover of Bear Stearns. If the financial world had to now absorb a second tranche of $500 billion or so, it is likely that the scale of the losses would crack open the system.
The measures proposed by House Financial Services Chairman, Barney Frank (Pictured), are designed to remove the risk of further losses from the banking system and borrowers and ensure that they are carried by tax-payers.
Instead of foreclosing, lenders would have to write down the value of the loan to 85% of the current appraised value of the property, and lend with any further losses to be covered by the government under a federal refinancing plan. This will cap the losses faced by the banks and enable them to start moving ahead without the uncertainty of maybe years fo subprime losses bleeding their balance sheets, making it impossible for banks to lend to each other, out of fear.
If the $1 trillion subprime loss becomes reality, the first $500 billion will be carried by the world’s banks. The second $500 billion will be carried by the US government, and therefore taxpayers. However bad the implications of that are, the losses of a collapsed economic system would far greater. It simply cannot be allowed to happen. The US government has the reassurance from China that it will play any role that is required to maintain the stability and functionality of the world’s financial system, on which all countries depend.
There’s a lot hanging on Barney Frank, and the US Congress, and the White House who can veto any proposals if it wishes. And the offer of Chinese money in the background can only help to bolster up confidence.