FYI | Aug 14 2007
By Greg Peel
The argument, as elucidated by “lawyer, writer, actor and economist” and CNBC favourite Ben Stein, in an article entitled “Chicken Little’s Brethren, on the Trading Floor”, goes like this:
“The total mortgage market in the United States is roughly $10.4 trillion. Of that, a little over 13 percent, or about $1.35 trillion, is subprime — certainly a large sum. Of this, nearly 14 percent is delinquent, meaning late in payment or in foreclosure. Of this amount, about 5 percent is actually in foreclosure, or about $67 billion. Of this amount, according to my friends in real estate, at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion.
“But by the metrics of a large economy, it is nothing. The total wealth of the United States is about $70 trillion. The value of the stocks listed in the United States is very roughly $15 trillion to $20 trillion. The bond market is even larger.”
Why then, queries Stein and many others, has US$1.1 trillion in value been knocked off the US stock market in recent weeks?
All through the recent credit market meltdown there have been persistent and almost desperate arguments put forward by increasingly incredulous bulls that the global economy is in great shape, earnings are still growing and price/earnings ratios are nowhere near the highs that pre-dated past collapses. Sure, the whole mortgage CDO thing got out of hand and a lot of people need to learn a hard lesson. It is unfortunate that some low-income Americans are losing their properties but this is a very minor aberration in the scale of things. Certainly there is no good reason on God’s green earth for financial stocks to be trashed completely. Let alone any reason companies with absolutely no connection to mortgages should also be sold down.
And Stein takes the argument a step further into the global marketplace:
“Foreign stocks, especially in developing countries, have been hard hit, and this is supposedly connected with a “repricing of risk,” which in turn is connected with subprime mortgages. But how are the risks in Thailand or Brazil or Indonesia intrinsically related to problems in a housing tract in Las Vegas? The developing countries are fantastically strong and liquid. Why should problems at a mortgage company in Long Island have anything to do with them?”
The BNP Paribas funds’ exposure to subprime was miniscule, notes Stein. Yet the single billion losses in France caused losses in the hundreds of billions in US markets on the news. He suggests “…the sell-off seems extreme, not to say nutty”.
Well Stein has a point. But either he is missing or refusing to believe some other points, or is just long and hurting.
Firstly, the market is down a bit over 6%. That’s not even a correction yet.
Secondly, the subprime crisis came to light in February after the Chinese stock market fell 9% in a day. What on earth would be the connection between the Chinese stock market and US subprime mortgages, Mr Stein? Well the connection is a perception of underpriced risk. Investment in emerging markets correlates to investment in junk debt securities only because both require an element of risk to be assumed on the part of the investor. So too have investors assumed risk by trading in volatile commodities and other asset classes. It doesn’t matter what the absolute losses are in subprime, and how they stack up against total global markets, what matters is that a sudden repricing of risk – which had fallen to unheard of levels of valuation – has ramifications for every market.
Thirdly, leverage. See above and multiply the consequences five to ten times.
Fourthly, despite having just questioned the relevance of the absolute value of subprime foreclosures, the numbers quoted reflect difficulties experienced by mortgage holders LAST year. The average move from difficulty to foreclosure is ninety days. Since February, things have only become more difficult. And not just in subprime. There are over US$1 trillion of adjustable rate mortgages about to adjust. And a significant number of prime equity loans in trouble as US house prices continue to fall. This is just the beginning.
Lastly, markets go up by the stairs and down by the elevator, to use a hackneyed expression. While fear might be irrational, fear cannot be dismissed. Or to abuse another hackneyed expression, even if we have nothing to fear we still have to fear fear itself. If you step out in front of a car clearly not slowing for a pedestrian crossing and end up in hospital, who’s the stupid one?
Stein says:
“I don’t know where the bottom is on subprime. I don’t know how bad the problems are at Bear [Stearns]. Yet I do know that the market reactions are wildly out of proportion to the real problems that have been revealed. Maybe there is some giant thing hiding in the closet that might rationalize the market’s fears. But if it’s hidden, how can the market be reacting to it in the first place?”
…which about sums up the speciousness of his argument. I don’t know this, I don’t know that, there might be something hidden but this is clearly an overreaction. If there’s so much he doesn’t know, why is it an overreaction? An overreaction to what?
“Some smart, brave people will make a fortune buying in these days,” says Stein, “and then we’ll all wonder what the scare was about”. Let’s hope for his sake he’s right.
Now, how might Mr Stein consider the impact of the US subprime mortgage market on a resource-rich Australian economy which itself has no subprime mortgages to speak of? Miniscule?
“What all these experts forgot,” wrote Crickey’s Glenn Dyer this morning, “is that with financial markets being global these days, the knock-on effect on interest rates, on share prices and on confidence from the gathering crisis in the US and in Europe spreads quickly. It’s arrived here in force today with a widespread slump in bank share prices because of a warning from the newly listed independent mortgage group, RAMS Home Loans Group”.
RAMS (RHG) warned this morning of a “material” impact on its finances, not because it issues subprime mortgages, but because of “widening ripples from the sub-prime implosion”.
Recently listed ($2.50) RAMS shares were down 32% ($1.19) at one stage today. Over to you again, Mr Stein. Would you have bought those shares yesterday?
