In the comments to my post Is the US Banking System Really Insolvent? Prof. Menzie Chin brought to my attention a wonderful paper: Leveraged Losses: Lessons from the Mortgage Market Meltdown.
This paper has also been highlighted on Econbrowser under the title Tabulating the Credit Crunch’s Effects: One Educated Guess.
The source document is in several parts – to do justice to it, I will be be posting reviews of each section.
The previous post in this series Economic Effects of Subprime, Part I: Loss Estimates, I had a look at the authors’ methodology of estimating loss. In this post, I’ll review their Section 3.4: Allocating the Losses.
Section 3.4’s main contribution to the the debate is “Exhibit 3.7: Home Mortgage Exposures of US Leveraged Institutions”, which uses unspecified Federal Reserve data to estimate that roughly 50% of all subprime exposure is held by US-based “Leveraged Institutions” – a defined term that includes Commercial Banks, Savings Institutions, Credit Unions, Brokers & Dealers, and the GSEs.
If we assume that the first three of those categories comprise all FDIC-insured institutions, then the numbers add up for RMBS exposure, more or less, anyway. The FDIC Quarterly Report on US Banks for 4Q07 has been previously discussed; the figure shown in Table II-A for “Mortgage-backed securities” is slightly over 1,236-billion, which is fairly close to the sum of the relevant categories in Exhibit 3.7 which is being examined.
So that part’s OK, but the purpose of the exercise is to determine the sub-prime exposure, not the total exposure; although there may well be losses on non-subprime paper, I think it’s pretty much agreed that these losses will be much lower, as a proportion of principal, than the losses on prime paper.
When we look at, for instance, Citigroup’s data on directly held mortgages (page 11 of the PDF), we find that the overwhelming majority of mortgages directly held are prime. Citigroup’s provides a vintage analysis of their $37.3-billion “Sub-prime Related Direct Exposures in Securities and Banking” on Schedule B of their Quarterly press release, but include the unfortunate caveat that:
Securities and banking also has trading positions, both long and short, in U.S. sub-prime residential mortgage-backed securities (RMBS) and related products, including ABS CDOs, that are not included in these figures. The exposure from these positions is actively managed and hedged, although the effectiveness of the hedging products used may vary with material changes in market condit
They are rather coy about the proportion of agency vs. non-agency RMBS held in their 2006 Annual Report, but state the total as comprising:
Mortgage-backed securities, principally obligations of U.S. Federal agencies
I don’t buy Exhibit 3.7 as evidence that US Leveraged institutions have exposure to half of the sub-prime losses. The quality of the banks’ (and bank-equivalents’, and GSE) exposure is going to be higher than average, tilted towards Agencies and AAA tranches of subprime; while “Brokers & Dealers” might – possibly – have a higher than average exposure to the mezzanine tranches, as might hedge funds, the focus is – or at least should be – on the banking system itself.
So where did it go? The Ashcraft paper, discussed in a dedicated post pointed out that the pension fund examined had all of its mortgage exposure in non-agency RMBS – I observed at that time that it was probably all AAA tranches at that. I note a Watson Wyatt press release stating:
January 30, 2007- Global institutional pension fund assets in the 11 major markets have more than doubled* during the past ten years and now total US$23,200 billion
and another release from the same firm:
October 3, 2007 – Total assets managed by the world’s largest 500 fund managers grew by 19% in 2006 to US$63.7 trillion according to the Pensions & Investments / Watson Wyatt World 500 ranking.
I suggest that these pools of capital (one will be almost entirely included in the other, by the way!) will be a fertile hunting ground for sub-prime exposure.
Exhibit 3.8 of the paper purports to support an estimate of 50% of losses being borne by the US leveraged sector, but the source of this table is a Goldman Sachs report with no reported methodology. I will note that the table estimates exposure of $57-billion for “Mutual and Pension Funds”; using the Watson Wyatt estimate of $23,200-billion for pension funds alone, this would imply that the average pension fund (taken from the 11 major markets) has exposure of about 0.25% of assets. Given 6.5% exposure in the fund in Ashcraft’s paper, this estimate seems a little low.
In conclusion … the evidence presented that half the sub-prime losses will be borne by the US leveraged sector is unconvincing. It should also be noted that the “bottom-up” estimate of Goldman Sachs includes 17% of total exposure in US Hedge Funds to reach this 50% total. A loss is a loss is a loss, and hedge fund losses will have some effect on the overall economy, but it seems to me that the transmission of such an effect to the economy will be greatly muted relative to the effect of such losses by banks. Hedge funds can be wiped out without much affecting the price of eggs.
Update, 2008-3-12: The source document is admiringly quoted in a John Dizard piece in the Financial Times, republished by Naked Capitalism:
Since the estimates were drawn up more than 15 minutes ago, they’re already out of date, but they’re not a bad place to start. The group estimates that the losses on mortgage paper will ultimately total about $400bn, with about half of that being incurred by “leveraged US institutions”. They go on to estimate that new equity raised so far from investors such as the sovereign wealth funds is of the order of $100bn.
…
It does not, therefore, take much of a leap in imagination to suggest that the US banks need to raise well over $100bn in new Tier One capital, and perhaps more than $200bn. They also need to do it quickly, so as to avoid that spiralling destruction of capital.