Subprime Daily Briefing, Dec. 21
By Arnold Kling
How I think it will all play out…First, another good yarn from Bloomberg.
Representatives of five of Wall Street’s dominant investment banks gathered around a blonde wood conference table on a February night almost three years ago. Their talks over take-out Chinese food led to the perfect formula for a U.S. housing collapse.
… While the group of five banks had packaged billions of dollars in subprime-based securities, in February 2005 none was among the leaders in the home-equity bond business. Countrywide Securities, RBS Greenwich Capital Markets, Lehman Brothers Holdings Inc., Credit Suisse Group and Morgan Stanley dominated the industry.
The banks wanted more mortgage-backed securities to sell to clients. Creating a standardized “synthetic” instrument, or derivative, would leverage small numbers of subprime mortgages into bigger securities. In this way, the firms could produce enough to meet global demand.
As for how this will play out, let me offer three scenarios.
1. Quick recovery. The liquidity crisis ends at the end of this month, when banks no longer need to worry about year-end window-dressing. Once the fraud loans have been cleaned out of the system, defaults start to slow down. Except in California, house prices start to rise by year end, as the slowdown in construction offsets the supply coming from foreclosures. Probability: 40 percent.
2. Severe recession in 2008-2009. The economy sinks under the weight of high oil prices, the liquidity crisis, and the loss of home equity. With unemployment rising, the default rate on mortgages keeps climbing. The economy experiences its worst recession in over 25 years. Probability: 25 percent.
3. Prolonged problems. Politicians keep fumbling the housing crisis forward. The economy grows, but slowly. House prices do not fall rapidly, but the market is very illiquid. In most of the country, home sales do not come back to normal until 2015. In California, it takes until 2020. Probability: 35 percent.