How big is the problem in the U.S. subprime mortgage market and to what extent will it slow economic growth?
This is the question haunting investors as mortgage market losses made their way onto bank and hedge fund balance sheets in recent weeks, forcing central banks to inject cash into banking systems to calm fears of a global credit squeeze as liquidity evaporated.
The losses from investments in U.S. subprime mortgages will be quantifiable eventually, but many are securitized and held in collateralized debt obligations (CDOs) whose terms add another unknown to investors calculations in the short term.
Nobody quite knows how much equity valuation is at risk here because it's on the books of a lot of less-than-transparent investment vehicles, said David Joy, market strategist at RiverSource Investments, a unit of Ameriprise Financial Inc.
And so you don't really know just what the potential is for a loss.
Estimates of losses on subprime mortgages range from $55 billion to as much as $100 billion, but the difficulty in assessing the damage is partly responsible for the indiscriminate selling of bond and stocks, Joy said.
This is in my mind evidence of the fact that investors are overly nervous precisely because of the unknown, said Joy, who oversees about $157 billion in assets. Joy added the fears are unfounded and that investor confidence will eventually return.
Jitters over the size and location of subprime mortgage related losses roiled markets anew on Thursday after France's biggest listed bank, BNP Paribas, froze 1.6 billion euros ($2.2 billion) worth of funds that invested in subprime mortgages.
Major central banks, including the Federal Reserve, have injected at least $323.3 billion into credit markets since Thursday to prevent them from seizing up.
Last week investment bank Credit Suisse estimated total defaults in the subprime mortgage market to be about $200 billion on some $1 trillion of outstanding loans. After recovery efforts, losses might be reduced to about $100 billion, Credit Suisse said.
HighMark Capital Management Inc. pegged potential losses over five years at $55 billion.
We just wanted to put a fence around what we think is the possible economic loss that subprime and Alt A would create, said David Goerz, who oversees about $20 billion in assets as chief investment officer at HighMark.
As the estimated value of investments, based on mark-to-market or mark-to-model valuations, has fallen in recent weeks, some investors have been asked to put up additional capital to support leveraged investments, but that does not necessarily mean investors are sitting on big losses, Goerz said.
The subprime component, about 10 percent of the overall $10 trillion U.S. mortgage market, is still healthy though because of the huge gains in home values over the last five to seven years, he said. Home prices would need to fall 30 percent or more on many mortgages before bonds would be impaired, Goerz said.
Because the price of the security has fallen doesn't mean the underlying collateral is actually not substantial enough to cover the bond, he said. That's the important point in all this.
The increase in U.S. home ownership has a flip side of increased losses and foreclosures, said Rod Dubitsky, managing director of asset-backed securities research at Credit Suisse.
You would expect dramatic increase in losses just because the market increased, Dubitsky said.
Although the number appears staggering, the subprime market would have generated losses equal to about 5 percent of loans in the best of circumstances, Dubitsky said.
Normally you'd expect a loss of $50 billion, he said.
Milton Ezrati, chief economist and market strategist at Lord Abbett & Co., said the $100 billion figure struck him as aggressive. But were losses of that magnitude to occur in one year, to put the size of potential losses in perspective, the U.S. economy has about $14 trillion in stocks, he said.
It's really hard to say subprime in and of itself can bring the economy down, Ezrati said. So even if that's concentrated in one year, it's manageable.
U.S. economic growth has moderated with consumer spending slowing as the housing market has weakened, and is expected to grow below 3 percent in the second half of 2007.
Investor jitters will ease on further signs the economy remains strong and signs the credit squeeze is being dealt with so that corporate deals can continue to get done.
Investor confidence also can be gauged by the performance of high- and low-quality debt, and currency prices, Joy said.
If the yen starts to appreciate it means that fear is still out there as people unwind their carry trades. If riskier assets continue to underperform higher quality assets then you known there is still a lot of fear out there, Joy said.
The one unknown that can raise its head again is fear that credit will stop flowing, said Ezrati, adding central banks adding liquidity is the correct action.
We can quantify what subprime is. We've gotten some notion of how big or relatively small it is. The unknown that is less quantifiable is how much fear will interrupt the flow of credit, Ezrati said. And it is completely unquantifiable, which makes it a much more frightening unknown.