Subprime global perspective

Want a better understanding of the global implications of the complex mechanisms that are used to fund mortgage lending today (or were used until August)? The International Monetary Fund has just published a new analysis of the potential fallout from the subprime lending collapse on global financial markets (hat tip to Housing Wire).

The report also presents some evidence that it may take some time for mortgage markets to return to normal -- despite Ben Bernanke's recent assurances to Congress that this mess may all be straightened out by March.

It's 175 pages, so here are a few highlights:

Although there were plenty of lenders getting into trouble with early-payment defaults in the first half of 2007, underwriting standards remained lax:

"...the combined loan-to-value ratios and credit scores on nonprime mortgages originated during the first half of 2007 were little changed relative to loans originated in 2006, and the percentage of loans with second liens actually increased. However, the average credit support required by ratings agencies on the securitized loans also increased, to account for the underlying poorer collateral quality."

"...some of the same risk layering characteristics endemic to the 2006 vintage appear to have persisted at least through the first half of 2007, despite reportedly tighter underwriting standards."

Interest rate resets won't peak until next year, and there's another wave of alt-A and pay-option ARM reset coming in 2011. This chart is from page 8 of Chapter 1 (click to enlarge).

Investors have lost their enthusiasm for "leveraged loans" -- investments with low ratings. Here's a chart from page 16 showing what happened to the bid price for leveraged loans. And you thought the decline in housing sales was precipitous.

On page 12 of Chapter 1, there's are rough estimates of losses on U.S. subrime and alt-A mortgages over the lifetime of the loans, and current "mark-to-market" losses using ABX indices. Mark-to-market losses are pegged at $200 billion -- a little more significant than the $34 billion back-of-an-envelope figure economist Ben Stein produced in August as evidence that wider impacts of the problems in subprime have been overstated. Although that may represent a "worst case" scenario, it doesn't include potential losses on subprime mortgage-backed synthetic collateralized debt obligations (CDO) because it's just too hard to estimate their value, the authors say.

Looking at the lifetime of the loans, iassuming that 25 percent of subprime and 7 percent of alt-A mortgages will default, with loss severities of 35 percent to 45 percent of the original amount outstanding, we're looking at up to $170 billion in losses, 25 percent of which would be "directly absorbed by the banking system." Ouch.

Also check out the "Stylized Example of a Forced Unwind of Leverage on page 21 of Chapter 1, which describes how after a 5 percent initial loss of value, a "structured asset" like the collateralized debt obligations used to fund mortgage loans can end up worth about one third its value after margin calls and a fire sale of assets to meet redemptions.)

The report also includes some interesting analysis of how we got where we are today.

On page 131 of the statistical appendix, check out the relentless rise in U.S. asset-backed securities outstanding (securities used to fund borrowing on everything from home and car purchases to credit cards and student loans).

There are also charts in the appendix illustrating who's funding all this debt (capital exporters) and who's borrowing (capital importers).

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