Comment 42: If mortgage woe worsens, what can FED do? (March 29, 2007)

Comment 42: If mortgage woe worsens, what can FED do? (March 29, 2007)

As has been pointed out in Comment 18, if lenders of mortgages are dumb computers that issue mortgages only according to the prevailing prices of houses but not on the ability of borrowers to carry the loans, a housing-price bubble will inevitably follow. The lucky home owners that cash out during the bubble will gain substantial spending power, but the power is derived from the future spending power of the whole society. When the housing-price bubble bursts, the ones still stuck with mortgages based on the inflated housing prices will be hit, and the spending power of the society as a whole will suffer accordingly. The current sub-prime mortgage woe is eerily similar to the escapade of dumb computers in Comment 18. However, before we rush into the conclusion that the sky is falling, we need to accurately assess the scope of the sub-prime woe, and investigate whether this woe may or may not spread to the broader mortgage market and negatively impact the whole economy. At the end we will warn that contrary to the simplistic views in the markets, the ability of FED to deal with a widespread mortgage woe may be limited due to the runaway US trade deficit.

The total amount of sub-prime mortgages outstanding is about 1.5 trillion dollars. It is reported that about 13% of sub-prime mortgages are delinquent, and about 6% are in default. That will place about 200 billion dollars worth of sub-prime mortgages in delinquency and 90 billion dollars in default. When a mortgage defaults, the actual loss to the lender is only a fraction of the outstanding amount since the underlining house is used as the collateral. Assuming that all the 13% sub-prime mortgage in delinquency will default eventually and the loss of lenders will be 20% of the face value of the mortgage in average for each default, the total loss from the sub-prime woe stands at about 40 billion dollars. This loss is not negligible, but is not large enough to trigger a chain reaction in the financial market, since those mortgages are already turned into mortgage backed securities and are held by numerous investors.

The impact of the sub-prime woe on the ordinary mortgage market can be measured by the behavior of 30 year fixed rate mortgage and its spread from the yield of 10 year treasury note. The rate of 30 year fixed mortgage was 6.18% at the beginning of 2007, rose to 6.34% at the end of January of 2007, but has fallen to 6.16% at the week of March 22. The spread between 30 year fixed rate mortgage and 10 year treasury note was +1.51% at the beginning of 2007, and has risen to +1.61% in recent weeks. From those observations we may conclude that some concern about the sub-prime woe is visible in the ordinary mortgage market, but the woe itself has not spread to the broader mortgage market yet.

If sub-prime woe escalates sharply, it will push up the yields of mortgage backed securities in general and may raise the rate of 30 year fixed loans to the crisis level. This kind of crises will be manifested in the sharply widened spread between 30 year fixed mortgage and 10 year treasury note. There is also the possibility that the yield of 10 year treasury note itself may rise substantially, and as the consequence carry the rate of 30 year fixed mortgage to the crisis level. In Comment 41 it has been pointed out that there are times when the crude oil price and the long-term interest rate are anti-synchronized. As crude oil price falls substantially, oil producing countries will be less capable to buy US treasury securities, and thus leads to higher long-term interest rate in US markets. In case that a crisis grips the general mortgage market, many think naively that FED only needs to lower the short-term interest rates to save the economy. Before the dawn of the era of the aggressive globalization process, that is, before the early part of 1980's, FED indeed had the ability to change interest rates at wish. However, with the persistent runaway trade deficit, FED has lost a substantial part of its sovereignty already. If FED wants to lower interest rates by a meaningful amount, it had better get the promise of Japanese Government to prop up dollar artificially at any cost, otherwise FED's action will induce the massive unwinding of yen carry trades, the unwinding will in turn stimulate a vast amount of capitals in US markets to run from dollar, and thus may cause the total collapse of dollar and the end of the current globalization process.