The headline numbers for the Great Real Estate Bust are scary:
And yet, the base numbers for the subprime market aren't scary at all. In fact, it looks like everyone is making a mountain out of a molehill.
The U.S. economy is very big, and by comparison, the subprime mess that Wall Street has gotten itself into is quite small. Subprime mortgages represent, at most, between 10 and 15 percent of the mortgage market. And of these, no more than 10 to 15 percent are in trouble. So, the messy portion of the mortgage market is somewhere between 1 percent and 2.25 percent of the total.
Even that amount, of course, overstates the portion of the market that is actually "at risk." The underlying collateral - the houses - are still there, and when the dust settles most will be sold for at least three-quarters of their mortgaged value.
In real terms, then, the total mortgage market stands to lose somewhere from one-quarter to about one-half of 1 percent of its value. This is an amount that a solid, blue-chip equity stock might lose in an hour's trading without causing an eyebrow to be raised.
Almost everything in these paragraphs is true. So if the Subprime Crisis is so small, why is everyone making such a Big Stink about it? The article goes on to blame "human nature", as if this is a Looney Tunes cartoon and the elephant just saw a mouse.
But what is happening in the credit markets isn't panic. There is something seriously wrong there. The worldwide credit markets are freezing up. These are professionals who don't panic because they saw a mouse.
The reason why this is happening is because the mortgage market isn't what it used to be. The current mortgage market can turn a $100,000 subprime mortgage into $2,000,000 in AAA-rated credit. How is that possible? Allow me to explain.
In the old days (i.e. 1980's) the local bank wrote their own mortgage and funded it. Those days are long since over.
Now the bank "originates" the loan but doesn't hold onto them. They package up your subprime mortgage along with several others into a derivative known as a collateralized debt obligations, or CDOs. The banks do this so they don't have to tie up a lot of capital on your mortgage, thus allowing them to loan out more money (which makes more profit).
Thus you can see why credit standards dropped during the last few years, as there was real incentive to push out as many mortgage loans as possible. Especially since the originating banks wouldn't be holding any of the risk once the CDO had been sold.
Insurance companies, pension funds and hedge-fund managers from around the world bought these CDOs. And with interest rates artificially low, especially in America and Japan, borrowing money was easy for these major players. Thus these CDOs were often bought with borrowed money.
The liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house.
These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper -- the short-term borrowings of banks and corporations -- which was purchased by supposedly low-risk money market funds.
According to Das' figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.
When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.
Notice the layers of borrowed money on top of borrowed money. It's a pyramid with the subprime mortgages at the bottom holding it up. So while the subprime market may only involve a couple hundred billion dollars in size, it is actually holding up trillions of dollars worth of loans in the world.
To put it another way, when a subprime borrower goes bust, it isn't just the $200,000 mortgage they defaulted on, the entire credit structure of $4 million dollar or so built on that mortgage also becomes worthless (or at least worth a LOT less).
At this point its also worth noting that while the banking industry is regulated, the CDO morket outside of the banking industry mostly isn't. These CDOs are packaged, sliced apart, and repackaged many times over, each time their credit rating goes up despite the underlying assets not changing. This makes it increasingly difficult to track the worth of the underlying assets. Does an insurance company in Munich, Germany really know the quality of a subprime mortgage in Oklahoma City? Do they have the time to investigate it? Or will they simply accept the rating of the bond?
Because they were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.
Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.
One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a vicious cycle.
And that suspicion is why this credit crisis isn't going to go away with a few rate cuts by the Federal Reserve. There is real reason to question the quality of all of America's financial assets.
If banks have to actually fund their own loans then there is less money available for such things as leveraged buyouts, short-term credit for businesses, and or course, mortgages.
This wouldn't be the first time in the history of capitalism that a financial structure has failed, and it won't be the last. We are looking at a long-term shake-out of a failed financial model.