The WaPo article is unconvincing to me.

He says the market value of toxic assets is between 5 and 30 cents on the dollar. Says who? If the market is so opaque, where does this number come from? What is it based upon?

Moreover, these assets are long-term assets (mortgages). The total market value of all US mortgages was $11.2 trillion in 3Q2008, and is trending down. US national income in 4Q2008 was $9.9T, down from $10.2T in 3Q. But personal outlays for housing has stayed very steady at about $1.5T. This is consistent with the hypothesis that people cut back on other expenditures, but kept consuming the same amount of housing.

So what does this mean?

About 67.5% of Americans own a home, so we can make a rough estimate of the total amount of personal outlays that are available to service mortgages: 67.5% * $1.5T = $1T.

Or put another way, Americans pay themselves $1T a year in rent to live in their homes, and that money can be used to pay their mortgage. Is it enough?

Let’s assume that the average mortgage has an interest rate of 6% (about where it has been for 10 years, more or less), and an average of 22.5 year amortization (a mix of 15 and 30 year). This means that their debt service (interest and principal) is about 8.2% of the principal amount. If the total amount of mortgage debt is $11.2T, so the annual debt service comes out to $920B.

So, in aggregate, there’s enough. Will Americans continue to be able to pay this? Most will, some won’t. The big trigger is unemployment – you can’t pay your mortgage if you don’t have a job (or enough savings until you get a job). But even if unemployment hits 10% (which seems likely), I would expect this to have only a modest impact on aggregate housing outlays (I’ll confirm this instinct with historical data when I get a chance). Delinquencies will rise, but there is a big difference between delinquency and foreclosure (delinquency rates range from 3.6% [prime fixed] to 22.1% [subprime ARM]; foreclosure rates are less than 2%). Just because you miss some payments doesn’t mean you’ll lose your house.

Anyhoo, the point here is that the claims that these “toxic assets” will sink the banks may be true, but without additional data to support this claim, I’m skeptical. There are losses, but I don’t see where $2T comes from. That would imply all mortgages would lose, on average, 20% of their value. I don’t see it.

This, incidentally, is the reason that we need a suspension of mark-to-market. There is a ton of data to process, and without some time to do that, the market (and therefore bank balance sheets) will continue to decline, even if it shouldn’t.

And, finally, WRT CDS: as discussed a while back, CDSs don’t increase the total losses, just their distribution. It’s a red herring.

Tasty, perhaps, but useless for cutting down a tree.

L3