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In my previous post Mortgage Spreads too High? I had used the formula: 

53% * 2,000,000 * $250,000 * (35% + 20%) = $145.75 billion

Let me explain. This is a standard expected loss formula adapted to our current situation. It takes the form:

Expected Loss = Prob of Default *  Severity of Loss

Given no reworking of loans, the probability of a default is 53%. The Severity of Loss is the average loss as a percentage of the loan, in this case 35%, multiplied by the average loan value. Depending on which paper you read, the average residential mortgage loss varies between 20+% to 60+%. The generally accepted figure is 35%. 

Given that a very large proportion of the loans are subprime, one can expect a Loan-to-Value (LTV) ratio of 100%, i.e. the average loan amout was the value of the property or $250,000.

I added an additional 20% to the loss as on a 100% LTV the unrecoverable loss needs to include the depreciation in house prices of 20%. This is appropriate as average losses are monotic and subadditive.

There is an important lesson here.

The formula tells us that if banks foreclose on a property they will have to realize the additional loss from the 20% house price depreciation. If banks have the capital to hold on to these foreclosed properties until the economy revives and house prices appreciate, then these banks do not require the government bailout funds, and should not be allowed access to the bailout funds.

This raises the question, how are banks using the bailout funds? If the bailout funds are being escrowed into reserve accounts for when a foreclosure is realized, then expect further deterioration in the mortgage markets in 2009; because the bailout funds are being used to stopgap bank losses but not to address the cause – the real economy.

If the funds are used to rework and rewrite mortgages so that 85% of the toxic mortgages are now viable, then we can expect a recovery in the mortgage market in 2009, because banks are addressing the problems in the real economy.

Now we know why Sheila Bair of the FDIC proposed a workout of 2,000,000 residential mortgages. In the long run it will actually help save the banks.

Unfortunately, as Paul Kruger pointed out in his New York Time’s blog, the spreads have increased to unprecedented highs. So don’t expect a recovery in the real economy of the mortgage markets until mortgage spreads come back down.

Benjamin T Solomon
QuantumRisk LLC

Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.

One Trackback/Pingback

  1. […] 8, 2009 · No Comments In my previous posts When to Expect a Recovery in the Mortgage Market, I had anticipated that banks would rework failed mortgages because that would be in their long […]

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