New Models Show $700 Billion In Credit Losses

How much will the credit orgy of the last 4 years end up costing the financial sector? So many estimates have been bandied about without explanation that I thought I would try to develop some clear models for estimating the carnage. I consistently came up with $700 billion dollars for each of the 3 models that I invented (remember, I invented them and I want credit!). With only $150 billion realized so far, that leaves $550 billion to go. In full disclosure, after evaluating my models, I went short financials via the SKF.

Before I review my models, let me define "credit losses" as all abnormal losses from bad mortgages and consumer credit. Subprime is just part of that equation. Total mortgage debt in the United States is estimated at $14.5 Trillion. Add in consumer debt of a little over 2.5 trillion and you get $17 trillion in total debt subject to default. That is the relevant number for this analysis. The one assumption that I make throughout is that some "extra" amount of consumer debt will default due to the housing collapse as homeowners can no longer use their home ATM to refinance their credit cards and other consumer debt (auto loans, etc.). I also assume some smaller losses due to foreign credit bubbles, mostly in Europe and Great Britain.

Method #1: Consumer Credit Model

1. Add up all transactions during bubble years: Using the National Association of Realtors stats on existing home sales and the Census Bureaus stats on new home sales, I come up with 30 million homes sold 2004-2008.
2. Calculate total dollar volume: Average sales price for the period was about $235,000. New homes were about $300,000 and existing about $200,000 with new home sales about 13% or so. 30 million x $235,000k = $7 trillion or so.
3. Calculate home equity extraction: Hard to find exact numbers as estimates varied, but 750 billion per year seems like a good average. 750 billion x 4 years = $3 trillion.
4. Total all transactions: Sales + equity extraction = $10 trillion in bubble year real estate based transactions!
5. Use average default rate for consumer debt of 5%. This is my secret sauce. I use cardrate.com data of 5% credit card write offs to estimate how much of the $10 trillion in housing transactions will come back to bite the financial sector.
6. Add up the damage: 5% of $10 trillion is $500 billion in losses. To that I am going to add $100 billion in abnormal losses on outstanding consumer credit and an additional $100 billion for bad loans in the rest of the world. Lax credit is not just a U.S. phenomenon. Total equals exactly $700 billion in losses.

Method #2: Learned Expert Discount Model

1. July of 2007: Bernanke estimated $100 billion. I believe that the Federal Reserve Chairman will generally under-exagerate a problem by 85% and always pick a manageable number lest he crash the stock market. So, I am going to inflate his number by a factor of 7, which gives me exactly $700 billion.
2. The Japanese Research Institute: Whoever these guys are, they say losses of $463.6 billion are in the cards, but they are in Japan where people don't even borrow money at 1% to consume. $700 billion sounds more American.
3. Deutsche Bank Securities estimated subprime losses at $400 billion. Germans have a reputation for precision, so I will go with that number and add in 300 billion more for prime losses including equity loans, bad consumer debt and "rest of the world" stuff. That comes to $700 billion exactly.
4. Bear Stearns pegged subprime losses at up to $250 billion. Hmm, Bear Stearns, lets see…Figure that their model is broken and double it, then add in other mortgage losses, foreign losses, etc. You get precisely $700 billion.

Method #3: Behavioral Finance Model Behavioral finance is a very exciting emerging field in finance. How will people behave when they find out that the property they financed is falling in value? What will the average upside down debtor do when he\she realizes that they can save a lot of money by mailing the keys back to the bank and renting? Stick it out and make payments on a property that they have no hope of ever "owning" or profiting on? Why would anyone do that? I overheard a couple arguing recently:

Husband: "Listen honey, I promised Angelo Mozilo that I would pay him back every dime that he lent us at that 1% teaser rate that just jumped to 14%. Angelo is a good man! We can't screw him! He trusted us!"

Wife: "Husband, you are an idiot. When we got married you promised to love, honor and cherish ME! Not Angelo Mozilo! We have kids! We can just rent for a couple of years and buy a new house at half the price of the old one."

Husband: "It is morally wrong!"

Wife: "You are an idiot. I am taking the kids and moving in with my Mom, I hope that you and Angelo have a great time sunning yourselves by the pool that we can't even afford to heat. Dumb ass!"

In fact, in speaking with some realtors that I know, it turns out that even people with good jobs and an ability to pay expect banks to eat caca when they can't sell their house for what they owe. As for the refinancing myth surrounding "poor homeowners who just want to stay in their homes," let me ask you a question. Why would anyone refinance a $500,000 loan on a $300,000 house? There is an old saying: "Fool me once when you sold me this over-priced POS shame on you! Fool me twice and let you refinance me on it, shame on me!" Giving Angelo Mozilo a $700 billion "happy retirement" middle finger is the precise result of applying my behavioral finance model.

Summary: So $700 billion is the number! Nah, actually, I really don't know, I am guessing. You didn't think I was serious did you? My methods are contrived, but they are as good as anyone else's. As for estimates that the media rely on, remember that the same people that we are supposed to trust with respect to estimating future losses are the same ones who told us there was no problem in the first place! The "there is no problem" era was less than 12 months ago! The "there is no contagion" era was 6 months ago! New Century Financial was still a multi-billion enterprise 365 days ago. Keep that in mind.

Do you think that in 365 days we not only discovered the problem, but that we have "put it behind us?" You will hear that repeated over and over for one simple reason, nobody knows how bad the problem is, and everybody is terrified at how bad it could get. Do you think Citigroup could have raised 2 cents in new capital if they had said $25 billion in write-downs was just the beginning? Do you think Bernanke would tell us if we had a $1 trillion problem? Do you think any investment bank would estimate a number that wasn't manageable? No. No. No. Hell no.

The reason that nobody can estimate the problem is that it is a psychological one as well as a financial one. When you think about this credit problem, you MUST keep human nature in mind. Factor in greed, anger, ignorance, pride, malice, fear and despair. Human nature is what got us here and human nature will determine where we end up. Don't ask yourself what millions of people will do when they can't make their mortgage payments. That is the easy question. Ask yourself what tens of millions of people might do when they can make their mortgage payment but just don't want to anymore. Use your knowledge about human nature, and then take that $17 trillion starting point and make up your own number. It will be as good as any number you hear reported anywhere. Then, invest accordingly.

Disclosure: Author is short SKF and XLF

Comments

[helplessobs...:]

Very informative. We are going to need a lot of rental units until this puppy is laid to rest.

2008 Jan 30 04:33 PM

[Richard Shi...:]

No problem on the rental units. Strategy: let bank foreclose, offer to rent it back for a year rather than make them "evict" you. Lots of negotiating power and it doesn't belong to the note holder. That is the key thing here, it is the old saying: lend a man 10 bucks, you own him, lend him a million, he owns you. Remember Trump in the 80's, he owed too much to let him fail, best that banks could do is to get him to do is to sell his yacht and limit himself to one mistress. I am not saying it is right or wrong, but it is what it is.

2008 Jan 30 05:30 PM

[David B:]

Good article , although in your disclosure you're short SKF & XLF which are opposite positions. I think you meant to be long SKF (which in itself is a short fund) & short XLF. Have i got that right?

2008 Jan 31 05:40 PM

[Richard Shi...:]

David B,

Yes, you are right, the submission form for Seeking Alpha does not let you break out short and long by position. That is why I mostly mention my positions in the article. SKF is basically a short on XLF.

Thanks.

2008 Jan 31 06:43 PM

[Dawson Lodge:]

Nice work, and your points are well taken about officials (read looters) downplaying the disaster. How about an arbitrage, sell the financials and buy the rental owners.
Are there any stocks that would benefit from a rush to apartment rentals?

2008 Feb 17 02:15 PM

[slade9992002:]

I have been going throw everything that is being said. My major thing in this this one is when banks make there loans they stopped thinking about the price of food and stopped looking at inflation factor of the dollar. Which is why the poor loan's. Instance if inflation keeps increasing and you buy a house for 100,000 and rate of payment is 800 a month and your income is 1600 a month you should be able to make it but in 5 years after the inflation on everthing else. The 800 dollars you originally had outside of your payment come's out to be 400 dollars which is only half of you started with when signing the papers. The money has to come from somewhere which usually end up in foreclusure and banks don't really look at that. Hence only one of the problems we have in the USA. In my personal opionion the crisis did not start here at all just feeding back into the system. And such this is the result and not the only one. Even if we solve this one it won't be to much longer before the other one's come up. If anyone would like to talk to me about this topics i would be more then happy to talk back to them about it. Email: [e-mail]

2008 Sep 25 07:49 PM