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NORTH AMERICAN & INTERNATIONAL ECONOMIC HIGHLIGHTS
The subprime mortgage default swap market may be pricing in a darker picture than the one likely to emerge,
but that will not help the valuations of American financial institutions in the coming months. An
unprecedented drop in house prices and the resulting surge in negative equity positions will continue to put
upward pressure on default rates. When all is said and done, mortgage-related writedowns will reach the
US$300 billion mark. But as opposed to the first wave, the next US$150 billion of global writedowns will be
led by insurance companies and numerous smaller players such as regional banks. This lack of concentration
should ease the pain.
We are in the midst of the worst US housing meltdown in the post-war era. Home sales are already down by
30% from their recent peak—the fastest pace of decline seen in any previous housing downturn. And the
50% drop in housing starts to date is already in line with the entire decline seen in the early-1980s housing
market correction.
But for this cycle, the bottom is not yet in sight, despite the dramatic slowing in the pace of home
construction. The excess number of unsold new and existing homes, based on their typical ratio to the total
stock of homes, has now reached the one million mark. To put that in perspective, that represents a full year of
construction by the US housing industry.
What really counts for markets is not the actual level of activity in the housing market, but what it will do to
home valuations. Already down by more than 8%, the Case-Shiller House Price Index (CSI) will continue its
descent in the coming quarters. Evaluated against benchmarks such as household income, and based on mean
revision estimates of some key house price drivers such as inventories, rent and average user cost, we project
that by the end of 2008, house prices will be roughly 20% lower than their late-2006 peak, and 12% lower
than their current level.
With every dollar drop in the value of their houses, more and more Americans find themselves in a negative
equity position. Zooming in on the 2006 vintage, no less than 30% of households who bought a house in that
year are already in a negative equity position. And by the end of the year, with house prices dropping by an
additional 10-12%, close to 50% of households in this vintage will find that their mortgages are larger than
the value of their houses.
With total subprime exposure at close to US$1.3 trillion and a weighted average loss rate of just under 15%,
we project that total cumulative subprime related losses will reach US$186 billion—of which more than 90%
are concentrated in the vintage years of 2005-2007. But the story goes beyond subprime. Alt-A mortgages,
which have seen their share in total mortgage originations rising quickly in the past few years, will add an
additional US$56 billion to the loss tally. And even prime mortgages, where foreclosure rates are already 60%
higher than the rates seen in the 2001 recession, will add to the pain. Sum it all up and you get a projected
total mortgage market-related loss of close to US$315 billion. With global financial institutions writing down
roughly US$150 billion of mortgage-related losses to date, we are half-way through.
Where will the next wave of losses come from? Banks and brokers will end up assuming more than half of
total mortgage-related losses. But this group has been aggressive in writing down assets against those losses.
With total cumulative writedowns of close to US$135 billion to date, banks and brokers have already
recognized more than three-quarters of their total projected losses. However, insurance companies, which will
end up losing roughly US$50 billion on their mortgage exposure, have recognized to date only a fraction of
that loss. Ditto for savings institutions and other players such as pension funds.
Also note that the lion’s share of the losses recognized to date were by large household-name banks, and
most of these writedowns were on their CDO exposures, which account for roughly 50% of total projected
losses. And with the ABX index currently pricing in the equivalent of close to US$330 billion in losses on
subprime paper alone—well above our US$186 billion estimate for the subprime component—banks, which
have been forced to mark to the ABX, may eventually benefit from write-backs if the index recovers and they
continue to hold their positions.