Econ 101 – Evaluate the Subprime Crisis Yourself

Many people are curious about the recent subprime crisis. Just like any former financial crisis (1933 Great Depression, 1998 Russian and Asian Crises), people panic and get nervous and anxious. Newspaper and seminars are everywhere. Professionals like the opportunity to give talks and make extra bucks. Anxious people like to ask questions, and professionals like to answer them (even with wrong answers, but who would know?) Everyone feels that they get something out of it. Everyone is satisfied!

My problem with all this is: “Have all these professionals taken Econ 101?” “Do all the seminars and newspaper columns make any sense?” “Do we need all these professionals to tell us what is going on?” “Can we, ourselves, judge the situation?”

A wise economist once said that “every recession comes with a different face”. I would like to quote that and say, “every crisis comes with a different face.” We should never try to make an analogy—we should try to “learn” it.

But how? That is the basic lesson of Econ 101. The basic economic principles will never change. For example, when demand exceeds supply, the price will rise. And vice versa: when supply exceeds demand, the price will fall. The basic economic principle here is a little more complex than supply-demand.

It is the principle of valuation. Valuation has to do with expectations. Expectations are vague and subjective. Vagueness provides professionals the opportunity to express their opinions and attract audience.

Why do we need to listen to other people’s, so called ‘professionals’, guesses? Why do we need to listen to anybody’s guesses? Why can’t we guess our own? The principle of valuation is not hard, just like the principle of supply-demand is not hard.

The principle of valuation is a “cash flow discount model” (CDM). It needs two inputs: expected (guessed) cash flows and discount rate. Then you divide the discount rate into the expected cash flows and sum all the “discounted cash flows” and there you go!

Although the model sounds simple, the inputs are hard to get. For example, how would you guess the cash flows of Lehman Brothers in the next 20 years? That is why professionals can give seminars. We believe that they know something about Lehman Brothers we don’t. We believe that they are INSIDERS!

The truth is nobody (except for the very few) is an insider. The professionals you listen to are not Dick Fuld (CEO of Lehman Brothers) or John Mack (CEO of Morgan Stanley). They are at most employees like you and I. The only reason why you listen to them and not they listen to you is that they do their homework. You can do your homework too!

All you need to do is to guess cash flows and discount rate. Here is a hot topic – subprime crisis. So lets do it.

We are evaluating the loss in the subprime crisis. This is much easier than the valuation of Lehman Brothers. First, we need to know how much is the entire subprime loans. For this we do not need to guess. The size of all subprime loans is a fact. There are data for it. However, these data are spread all over the places. Unless you pool all the banks in the mortgage world, you cannot obtain this number. Luckily there are ways to get around it. There are historical statistics of mortgages. For example, historically subprime loans account for about 4 or 5% of all the mortgages. Currently the entire mortgage size is about $10 trillion; so the subprime loans are about $400~500 billion. Due to the loosened subprime lending (many frauds have been reported on this) and hence the percentage may have risen, we conservatively double the size of it for the crisis – $1 trillion. Guess what, this is very close to what recently HUD and FED have reported.

Out of $1 trillion total size, how much is the loss? This depends on the real estate market (that is why recession will HUGELY worsen the crisis). For a loan to take a loss, it must be that the real estate value is less than the loan amount. If LTV (loan to value ratio) is 80%, then there is 20% buffer for the real estate value to drop and still not have any loss. In other words, only if the house value drops by more than 20%, the subprime lender will suffer any loss. If LTV is 100%, then there is no buffer (now you can see how significantly frauds can cause losses).

Currently professionals are very pessimistic and are only willing to give 50% recovery value. This means we will lose half of $1 trillion, or $500 billion, in subprime loans. Banks have already started taking losses. Up to date (4/27/08), there have been about $100 billion losses already recognized. So there are $400 billion more to come! This is pretty darn bad! How many more Bear Sterns we can take in the economy!

But the key is professionals assume 50% recovery. But do you know that traditionally prime mortgage loans recover about 85%? True, subprime borrowers are less reliable than prime borrowers. But that has nothing to do with recovery. Recovery relies solely on the real estate value. If the recovery is 85% for subprimes, then the loss becomes $150 billion. Then the crisis is already over.

So the real question you should ask yourselves is: “How much recovery we should assume for the subprimes?” Can you not have a guess? Do you need someone to guess it for you?

I don’t think so. We all have equally very poor idea about the economy in the future. Even the best professionals are wrong all the time about future economy. So why rely on other people to tell you what to do? We invest in stocks, don’t we? Aren’t we forecasting (at least trying) economy all the time?

Subprime problems started at the peak of the real estate bubble, which was around 2006 and 2007. Defaults and foreclosures about these loans have just started. Typically the foreclosure process takes many months (somewhere between 6 to 9 months). Hence, by the middle of this year, we should have a good idea how the early 2006 subprime loans that had gone defaulted recover. Then we can estimate again how good or bad the entire loss is going to be.

After calculating the loss yourself, should you panic? Do you think the economy should go to recession because of this? Do you think the bankruptcy of Bear Sterns should have a real impact on our economy? Most importantly, should you sell you stocks to enhance the panic?

I am not a professional; I cannot tell you what to do. You have learned Econ 101. You decide.

Ren-Raw Chen

a finance professor at Rutgers University and

a lost individual who does not know what to do just like you.

p.s. Does anyone know some really good seminars? Please mail me @ rchen@rci.rutgers.edu