The final owner of the mortgage, of course, is the loser. The assumption that subprimes could be refinanced if need be failed to take into account that higher interest rates priced these people out of the market. But the worst part is this: Many hedge funds leveraged their purchase of mortgages by using them as collateral to borrow money from the banks.
That was the tipping point. When the subprime defaults started to hit, the banks that had loaned money against the mortgage portfolios re-evaluated the loans. They called some, they stopped rollovers of others and they raised interest rates. Basically, the banks started reducing the valuation of the underlying assets -- subprime mortgages -- and the internal financial positions of some hedge funds started to unravel. In some cases, the hedge funds could not repay the loans because they were unable to resell their subprime mortgages. This started causing a liquidity crisis in the global banking system, and the U.S. Federal Reserve and the European Central Bank began pumping money into the system.
Told this way, this is a story of how excess emerges in a business cycle. But it is not really a very interesting story because the business cycle always ends in excess. As economic conditions improve, more people with more money chase fewer investment opportunities. They crowd into investments that seem to guarantee vast or sure returns -- and they get hammered. The economy contracts into a recession, as it tends to do twice every decade, and then life goes on.
There currently are three possibilities. One is that the subprime crisis is an overblown event that will not even represent the culmination of a business cycle. The second is that we are about to enter a normal cyclical recession. The third, and the one that interests us, is that this crisis could result in a fundamental shift in how the U.S. or the international system works.
We need to benchmark the subprime crisis against other economic crises, and the one that most readily comes to mind is the savings and loan crisis of the 1980s. The two are not identical, but each involved careless lending practices that affected the economy while devastating individuals. But looking at it in a geopolitical sense, the S&L crisis was a nonevent. It affected nothing. Bearing in mind the difficulty of quantifying such things because of definitions, let's look for an order of magnitude comparison to see whether the subprime crisis is smaller or larger than the S&L crisis before it.
Not knowing the size of the ultimate loss after workout, we try to measure the magnitude of the problem from the size of the asset class at risk. But we work from the assumption that proved true in the S&L crisis: Financial instruments collateralized against real estate, in the long run, limit losses dramatically, although the impact on individual investors and homeowners can be devastating. We have no idea of the final workout numbers on subprime. That will depend on the final total of defaults, the ability to refinance, the ability to sell the houses and the price received. The final rectification of the subprime will be a small fraction of the total size of the pool.
Therefore, we look at the size of the at-risk pool, compared to the size of the economy as a whole, to get a sense of the order of magnitude we are dealing with. In looking at the assets involved and comparing them to the gross domestic product (GDP), the overall size of the economy, the Federal Deposit Insurance Corp. estimates that the total amount of assets involved in that crisis was $519 billion. Note that these are assets in the at-risk class, not failed loans. The size of the economy from 1986 to 1989 (the period of greatest turmoil) was between $4.5 trillion and $5.5 trillion. So the S&L crisis involved assets of between 8 percent and 10 percent of GDP. The final losses incurred amounted to about 3 percent of GDP, incurred over time.
The size of the total subprime market is estimated by Reuters to be about $500 billion. Again, this is the total asset pool, not nonperforming loans. The GDP of the United States today is about $14 trillion. That means this crisis represents about 3.5 percent of GDP, compared to between 9 percent and 10 percent of GDP in the S&L crisis. If history repeats itself -- which it won't precisely -- for the subprime crisis to equal the S&L crisis, the entire asset base would have to be written off, and that is unlikely. That would require a collapse in the private home market substantially greater than the collapse in the commercial real estate market in the 1980s -- and that was quite a terrific collapse.
Now, many arguments could be made that the estimates here are faulty or that different concepts should be used. We will concede that there are several ways of looking at this crisis. But in trying to get a handle on it strictly from a geopolitical perspective, this gives us a benchmark with which to analyze the mess.
Can it balloon into something greater? The big risk is that the weak hands in the game, the hedge funds, are suddenly coming into possession of a great number of houses that they will have to put on the market simultaneously in fire sales. That could force home prices down. At the same time, most homes are not at risk, and their owners are not hedge funds. Moreover, it is not clear whether most of the hedge funds that own subprime mortgages will be forced to try to monetize the underlying assets. It is far from clear whether the crisis will affect home prices decisively. If home prices were to collapse at the rate that commercial real estate collapsed in the 1980s, we would revisit the issue. But, unlike commercial real estate, in which price declines force more properties on the market, home real estate has the opposite tendency when prices decline -- inventory contracts. So, unless this crisis can pyramid to forced sales in excess of the subprime market, we do not see this rising to geopolitical significance.
From this, two conclusions emerge: First, this is far from being a geopolitically significant event. Second, it is not clear whether this is large enough to represent the culminating event in this business cycle. It could advance to that, but it is not there yet. We cannot preclude the possibility, though it seems more likely to be a stress point in an ongoing business cycle.
Apart from discussing the subprime issue, this crisis offers us an opportunity to explain how we view economic activity. First, we try to understand, at a fairly high level, what exactly happened, much as we would approach a war or a coup. Then we try to compare this event to other events whose outcomes we know. And, finally, we try to place it on a continuum ranging from fundamental geopolitical change to normal background noise. This is more than normal background noise, but it has not yet risen even to the level of a routine, cyclical shift in the business cycle.
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