Just How Big and How Bad is the Subprime Mortgage Problem?

I have been trying to get my mind around the subprime problems for months. I keep asking myself the same questions everyone is asking: how can it be so bad and so widespread, who's next, and who or what am I missing? Over this past weekend, I decided to take a 30,000 foot look at the situation to see if I could make more sense of the crisis from that perspective than I had been able to wading around in the fast flowing currents of the news of the day. It occurred to me that the macro approach would at least offer a way of putting the subprime crisis into perspective, relative to the US economy. I quickly found that there is as much bad data on the subject as there is good. In truth, no one knows what the ultimate outcome will be; however, I found a way of thinking about the issue that made sense to me, and I have seen others coming to conclusions that are similar to mine.

1. Subprime is about 13% of the $10 trillion total mortgage market, or about $1.3 trillion.
2. Currently about 17% of subprime loans are delinquent. For our purposes here, however, let's assume that 50% of subprime loans ultimately default.
3. That would put the total defaults at $650 billion.
4. But remember these loans are backed by homes, so let's assume that when the homes are ultimately sold, the debt holders will receive 50 cents on the dollar, or $325 billion.
5. My study of the situation indicates that the banks and investment banks sold about 50% of the loans to insurance companies, retirement plans, hedge funds, private equity groups, etc., and kept the rest. That would put the amount in banks and investment banks at near $163 billion.
6. Next, assumed that approximately 70% of the loans stayed in the US and 30% went abroad. That would give us a final exposure to the US banking system of near $115 billion.

That figure would lean toward a worst case scenario. As of today, nearly $55 billion in write offs have been announced. On the surface it would seem that we have a lot of pain left to endure. But remember, even if the worst case comes to pass, it will not happen immediately because, as I said earlier, this exercise assumes 50% of subprime loans default, whereas, only 17% are delinquent today. Finally, if the ultimate losses do total the aforementioned figure, it will represent only .8% of US Gross Domestic Product of nearly $14 trillion, or put another way, less than one year of US bank earnings. I am confidant that if the problem is of the size I describe here there will be no lasting effect on the economy or the vast majority of banks. The only caveat to this line of thinking is it is hard to imagine that things have deteriorated so rapidly and we don't know how other parts of the economy will hold up under the stress of the real estate malaise. In this regard, the recent earnings reports were mostly favorable, but the Christmas selling season is very important to the US economy, so we won't have conclusive data until January. I am receiving many terrific questions from clients about our firm's views on a number of subjects. We will do our best to answer each question here so everyone can be informed. Next time we will look at some Consumer Staples companies we like, and some we don't.