Arnold Kling  

Subprime Daily Briefing, Dec. 21

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How I think it will all play out...

First, another good yarn from Bloomberg.


Representatives of five of Wall Street's dominant investment banks gathered around a blonde wood conference table on a February night almost three years ago. Their talks over take-out Chinese food led to the perfect formula for a U.S. housing collapse.

... While the group of five banks had packaged billions of dollars in subprime-based securities, in February 2005 none was among the leaders in the home-equity bond business. Countrywide Securities, RBS Greenwich Capital Markets, Lehman Brothers Holdings Inc., Credit Suisse Group and Morgan Stanley dominated the industry.

The banks wanted more mortgage-backed securities to sell to clients. Creating a standardized ``synthetic'' instrument, or derivative, would leverage small numbers of subprime mortgages into bigger securities. In this way, the firms could produce enough to meet global demand.


As for how this will play out, let me offer three scenarios.

1. Quick recovery. The liquidity crisis ends at the end of this month, when banks no longer need to worry about year-end window-dressing. Once the fraud loans have been cleaned out of the system, defaults start to slow down. Except in California, house prices start to rise by year end, as the slowdown in construction offsets the supply coming from foreclosures. Probability: 40 percent.

2. Severe recession in 2008-2009. The economy sinks under the weight of high oil prices, the liquidity crisis, and the loss of home equity. With unemployment rising, the default rate on mortgages keeps climbing. The economy experiences its worst recession in over 25 years. Probability: 25 percent.

3. Prolonged problems. Politicians keep fumbling the housing crisis forward. The economy grows, but slowly. House prices do not fall rapidly, but the market is very illiquid. In most of the country, home sales do not come back to normal until 2015. In California, it takes until 2020. Probability: 35 percent.


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COMMENTS (6 to date)
Bob writes:

Given that each scenario is given a roughly 1/3 probability, the lead should read "how it may play out."

I propose that we test the aggregate wisdom of the readers of econlog and all weigh in on the probabilities of the three:

I "vote" 50-50-0

Bob writes:

BTW, so folks are not tempted to add their own scenarios, let's call them

1) quick recover beginning by end of 2008
2) recession that delays recovery past 2008
3) housing stagnation (neither recession nor recovery) that extends well past 2008

I think this covers all bases.

spencer writes:

I've been giving the prolonged stagnation scenario top probability for over a year.

Patrick writes:

Interesting. I don't understand how/why so much weight is being given to "quick recovery". It seems quite clear that we'll suffer a slowing economy as the housing bubble - and make no mistake, there is still a bubble - deflates.

I'd vote: 20-60-20

Stephen Forde writes:

By what means do you calculate your probabilities?

One might just as easily weigh your three scenarios like this.

20-20-60
2-90-8
30-10-50

Or they may also just add another category for any other scenario, since it is possible that things might occur in a way other than any of the three scenarios described above, and in order to be logically complete a set of all possible events must include all other possibilities as well. And then they might weigh it like this.

10-30-10-50.

Now, suppose I pinned up three on a wall nad had a monkey throw a hundred darts at the board. Add a percentage point of probability to each of the categories.

Now, can you give a justification for your probabilities any more objective than the method described above?

Stephen Forde writes:

Second last sentence should read as:

Start at 0 probability for each of the categories, and add a percentage point for each category that the monkey hits with one of the darts.

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