BuildingTeam Construction Forecast

Notes from Jim Haughey

Reed Construction Data Chief Economist Jim Haughey discusses how current developments in construction markets and the ecomony will bring opportunities and challenges for designers, contractors, and materials and services providers. His reports will cover near-term building demand, cost and financing changes, and will provide early notice on changes in the detailed two-year construction forecasts elsewhere on this site. Feedback and questions from readers are encouraged.

Tuesday, October 23, 2007

Subprime Default Hot Potato Still Being Tossed About

Oct 23 2007 6:10AM | Permalink | Email this | Comments (0) |
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Four months after it became clear that subprime and Alt A residential mortgages were not worth as much holders paid for them, the financial markets are still sorting out which investors will take the losses. It does not matter to contractors and their suppliers who absorbs the capital losses on these bad mortgages as long it is done slowly and gracefully and without any abrupt negative jolt fed back to the broad economy and hence to construction demand.

The Federal Reserve board minimized the initial shock to the economy last summer. Now the Treasury Department and large banks have taken the lead to prevent significant defaults among the investment funds that hold securities backed by mortgages and other assets. Defaults among these funds are currently the key financial threat to the economy. The default of one these funds, often termed Structures Investment Vehicles (SIV), could cause a cash flow crisis for one of its creditors and set off a round of liquidations — plunging asset prices — to cover loan repayment obligations.

The problem has become much bigger than just a known quantity of bad mortgages. First, investors are not yet sure how to price the bad mortgages. Second, they are not sure how much of the portfolio of each of their borrowers consists of bad mortgages. Third, they are not certain that the financial turmoil can be kept from the broader economy where it would reduce the value of all assets.

Investors are not certain how to price mortgages. They relied on bond rating services to do this but now know that the rating services were unable to detect fraud and priced mortgages and mortgage backed commercial paper too high. When in doubt, investors are cautious. Investors are also concerned that the regional concentration of defaulted mortgages will sharply reduce the price received for homes at foreclosure sales as well as lower prices elsewhere in the same region and set off more defaults.

As a result, these funds that borrow short-term, typically at lower interest rates, to finance mortgages and other long-tem assets are having difficulty rolling over short-term debt to their lenders who are now suspicious about how many bad mortgages are in their borrowers’ asset portfolio and how high the foreclosure losses will be.

We will not know if the Treasury initiative worked for at least another month. The prospects look good that the Treasury can let the air out of the asset bubble slowly so that it does not jolt the economy and panic consumers. The plan is to tap large banks to fund a new investment pool that will buy and hold the highest quality items in the portfolios of the Structured Investment Vehicles, many of whom are owned in part by the banks themselves. Separating the good paper from the bad paper will let most of the asset backed commercial paper market return to normal operating conditions and prevent a jolt to the economy. The holders of the securities backed by troubled mortgages will have to take write downs.

Yes, this is the banks’ right hand swapping assets with the banks’ left hand. How does this do any good? It buys more time by keeping the hot potato in the air a little longer while investors become more comfortable pricing assets and are able to rescue the fundamentally sound commercial paper.

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