by Martin Hellwig; in MaxPlanckResearch 3/09
The figure of 500 billion dollars in losses is too low to explain why the global financial system, with bank assets of 80 to 90 trillion dollars, was dragged into the abyss. Back in 1990, the losses incurred by the US savings and loan associations were said to amount to some 600 to 800 billion dollars. In the Japanese banking crisis of the 1990s, the banks’ actual losses amounted to more than 500 billion dollars. In neither case did the crisis have any repercussions for the global financial system as a whole.
At the same time, the figure is too high to be explained by lowered expectations of debt service on subprime mortgages. As of October 2008, the IMF estimated the total volume of non-prime mortgages at some 1,100 billion dollars.
Losses of 500 billion would imply a loss rate of 45 percent. If borrowers initially had, on average, 5 percent equity in their homes, a loss rate of 45 percent on the mortgage would imply a loss rate of 50 percent on the value of the underlying real estate. Between mid-2006 and mid-2008, however, real estate prices in the United States dropped only 19 percent on average, with the worst hit metropolitan areas recording a 33 percent decline.
Admittedly, this back-of-the-envelope calculation is over-simplified, but the main point is that the IMF’s loss estimates refer to market prices of mortgage-backed securities, not to the debt service on the underlying mortgages. The two are not the same and, as the IMF points out, there are good reasons to believe that market values are significantly below present values of expected returns on the underlying mortgages, either from the borrowers’ debt service or from foreclosure proceeds. The fact that market values are too low is due to systemic interdependence. The financial crisis is thus not just a matter of subprime mortgages and gambling bankers. The crisis is also due to some fundamental flaws in the architecture of the international financial system. Indeed, many devices that were supposed to serve as fire extinguishers have in fact worked as fire enhancers, adding yet more fuel to the flames. Part of the blame for this must be given to statutory regulation. In principle, it is a good idea to shift some of the risks of real estate finance to third parties. Problems in real estate markets have always been among the most important causes of financial crises, as was the case in the banking crises of the late 1980s and early 1990s. Real estate finance is problematic because, in terms of economic aggregates, the values involved are high relative to the overall wealth of the economy. Moreover, the economic lifespan of a typical real estate investment extends far beyond the time horizon that the typical saver envisages for his investments.
The discrepancy between the economic lifespan of a real estate investment and the time horizon of the typical saver is a major source of risk. If a real estate investment is financed by short-term loans, the borrower faces the risk that, when these loans come due, he may be unable to refinance the property. If the investment is financed by long-term loans, the financier faces the risk that, if he wants to liquidate his holding prematurely, he may not be able to do so, or the price may be quite low.