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Some ballpark math on the US financial sector (i.e. just how big is $700b?)

by Brad Setser
September 23, 2008

The Federal Reserve’s flow of funds data indicates that US households have $11.2 trillion in outstanding mortgage debt on non-farm homes, another $2.4 trillion in outstanding “other mortgage debt” (a category that includes corporate farms, who knew … ) and $2.5 trillion outstanding consumer credit.

Figuring out how much households owe is the easy bit. Figuring out who owns the debt of US households is a bit harder.

For now, I am going to focus on the $13.6 trillion in mortgage debt. The Agencies have $7.9 trillion in debt and guaranteed bonds outstanding, but the GSEs hold around $800b of the debt that they guarantee, so their total holdings of mortgages and mortgage backed securities is more like $7.1 trillion. Like the Agencies or not, no financial institution is going to go bust holding Agency debt. That leaves around $6.5 trillion of outstanding mortgage exposure in the hands of the financial system, give or take. It might be higher because it is possible to create “synthetic exposure” to various kinds of securities — basically, financial institutions can make a side bet among themselves about the future value of a mortgage backed security. That exposure nets out, but the netting only works if the losing party to the bet can pay up (Note: this paragraph has been edited in light of the comments, which highlighted that my initial post failed to reflect the Agency backed mortgage pools held by the GSEs)

This math is not inconsistent with the Fed’s data on the outstanding stock of asset backed securities. There are $4.365 trillion in asset backed securities outstanding. Not all those contain mortgages, but many do. Table L 126 suggests that ABS issuers hold about $2.1 trillion in residential mortgages, another $640b in commercial real estate and a non-trivial $400b in Agency debt.

This math also seems consistent with data indicating that the commercial banks hold $3.7 trillion in mortgages and another $1 trillion in corporate bonds (a category that should include ABS) — i.e. up to $4.7 trillion in exposure. The thrifts report about $1.2 trillion in mortgage exposure — mostly from mortgages, “private” MBS and collateralized mortgage obligations (CMOs) sum up to under $100b — see table LII4). The broker dealers have $270b in corporate bonds (think ABS) — not a huge exposure. But they over half ($1.6 trillion of a $2.8 trillion total) of their assets is just labeled other.*

Willem Buiter thinks that the US Treasury will be buying up assets at roughly 33 cents on the dollar, which would broadly speaking move $2 to $2.1 trillion in face value of debt off the balance sheets of major US financial institutions. Buiter:

I assume that $700 bn will allow the purchase by the US Treasury (or its agents) of at least $2 trillion worth of mortgage-related securities at face value, as it would not make sense for the US tax payer to pay much more than 33 cents on the dollar for the mortgage-related rubbish that banks have loaded onto their balance sheets.

That would leave, on first approximation, $3.7 or $3.8 trillion of mortgage exposure in the hands of the financial institutions.

I am not though convinced that the banks can afford to sell at 33 cents on the dollar. If these assets were valued at par before the crisis, I think that implies taking an aggregate loss of $1.4 trillion — which seems much higher than the losses that the banks have recognized to date. The hit to the banks balance sheet might be too big.

My guess is that the Treasury’s average purchase price will be a bit higher — which implies that fewer bad assets will be moved off the aggregate balance sheet of large financial institutions.

What is the point of all this?

Well, to me it helps to highlight the challenge the Treasury faces. If it pays a high price for various dud assets, it won’t move nearly as much off the banks’ balance sheet — which may leave residual questions about the health of key institutions. On the other hand, if the Treasury pays a low price, it may leave a lot of banks in trouble and in desperate need of new equity.

It also helped me try to think through whether $700b is a lot a money or a little bit of money, relative to the enormous challenges the US now faces supporting a financial sector that is gravely ill. I was reminded just how big the balance sheet of the US financial sector is — and just how much of that balance sheet is tied up in the real estate market.

Finally, I wanted to see if others found this kind of analysis – call it the beginning of a balance sheet analysis of the US — at all helpful to a broader range of people before I try to go further.

*Since q2 2007, the broker dealers have reduced their holdings of corporate bonds from around $420 to around $270b — a meaningful fall. From q2 2007 on, their agency holdings soared from $120b to $310b. Total assets though from $3.2 trillion in q2 2007 to $2.9 trillion in q2 2008, so there was a bit of deleveraging, not just a shift toward Agencies. That though likely corresponds with the collapse of Bear. The bigger trend is probably less a brutal deleveraging and more the end of the rapid growth of broker-dealer balance sheets.

From the end of 2003 to q2 2007, the broker-dealers total financial assets (and liabilities) basically doubled. That seems to correspond with a rapid increase in their aggregate leverage. The expansion of their balance sheet was especially rapid in 2006 (up over $600b) and the first half of 2007 (up $400b). That expansion led to a roughly $100b increase in the broker dealers holdings of corporate bonds, but most of the growth came from “other” assets. See table L. 129. By comparison, figuring out what China holds is easy …

127 Comments

  • Posted by Andrew Foland

    As I noted over at CR’s last night, the total of the top 20 financial holdings of Level 3 Assets, excepting Fannie, Freddie, and AIG which have already been accounted for, is $755BB. Anything outside the top 20 is chump change.

    I suspect that all financials’ Level 3 Assets, paid for at their current marks, may not be a bad place to look for where they came up with the dollar figure.

  • Posted by Twofish

    slumlord: Whats to stop Goldman selling its crap to Treasury for 95cents in the dollar and then buying it back at 60?

    In the AIG and Freddie and Fannie bailouts, the government ended up with shares of AIG and Freddie/Fannie, so if Goldman did this, then Feds can exercise their warrants recover their money.

    The question then becomes what makes you think that Paulson won’t do a sweetheart deal, and the answer is that the Treasury Secretary is hired by the President who you elect. The fact that this answer is not good enough for a lot of people is why people are adding clauses to the bill as we speak. Paulson is not going to get a blank check.

    slumlord: Who the hell would want to investing in housing when the return can be arbitrarily modified by a Judge

    Fewer people investing in housing is not a bad thing, and the judge is merely the messenger of doom. The house has already lost its value, and probably *NEVER* was at the price that the bank put out the loan for.

    The judge just makes it official, and having a situation in which people are forced early on to deal with losses rather than hide them, seems like a good thing to me. If you want to argue that the pile of crap is really gold bricks, then you can do it in bankruptcy court.

    In any case, it’s not fair that big companies get bailed out if little people are stuck with the price tag which is what *will* happen if you don’t have bankruptcy provisions.

    The reason the clock is ticking now is that once the assets of Lehman get put before a bankruptcy court, everyone is going to have to remark their assets prices, and it’s not going to be pretty.

  • Posted by Twofish

    Brad: If Glass-Steagall had remained in effect, limiting commercial banks to say the 5% or 10% broker activity derived revenue, would this crisis have such far reaching implications that it threatens the (relatively simple) financial transactions required to run business from day to day.

    I really don’t think so. The big mega-banks aren’t the one’s falling from the skies. This is for several reasons.

    1) The first is that the big mega-banks have more capital and so their investment banking operations are less prone to volatility and they are less prone to take risks and use leverage.

    2) The second is that when you merge an investment bank with a commercial bank, the combination becomes much more tightly regulated since you have both the securities regulators, the banking regulators, and the federal reserve looking at the combination.

    3) Third, you end up with information sharing. In the mega banks you had the people running mortgages telling the investment bankers that people were starting to not pay their mortgages, and so they were less exposed than pure investment banks.

  • Posted by slumlord

    Twofish:

    “in any case, it’s not fair that big companies get bailed out if little people are stuck with the price tag which is what *will* happen if you don’t have bankruptcy provisions.”

    Totally agree. That’s why I’m opposed to the bailout as is. The problem is however lending money to people who want to use it for whatever reason is intrinsic to capitalism. Borrowing is what funds homes, factory’s and other productive endeavours. You want people to keep borrowing even during an economic downturn. Making lending risky from the point of the view of the lender is not such a smart idea, especially in an economy that will be shrinking. Irrational lending can be both permissive or restrictive, you don’t want the second option in a recession.

    Paulson wants carte blanche; the fact that he cant get it is a feature of the constitution, not the President. Bernake has gone on the record to say that he wants to pay above current market prices for the waste. Why doesn’t he just come out and say that he wants to give the banks a grant? Because it politically unacceptable, therefore the shenanigans.

    I reckon any government intervention in the markets may lessen the initial pain but will prolong its duration. Look, 700 billion would probably be better spent on trying to repopulate the middle class through productive means. House prices have to come down, incomes have to rise and dumb banks have to fail.

    Financial pain is intrinsic to capitalism. It does not insulate people from financial misjudgment. This current crisis is capitalism working normally.

  • Posted by pseudorandom

    Twofish: That will help you if you have a liquidity problem, but not if you have a solvency problem. Once everything gets sorted out it is likely that a lot of banks will not have enough assets to cover deposits, and new deposits will not help. If you deposit $20 into a bank, the bank now owes you $20, and so the banks net position was the same as it was before.

    With time, the banks will eventually get recapitalized. Time is on the side of banks because their assets invariably yield more than their liabilities.

    Twofish: When you give a bank $20, you do expect it back don’t you?

    Eventually. See above.

    Twofish: A job is by far the most important asset people have. When you go to apply for a loan, how much money a bank is willing to loan you is largely based on how much money you make.

    I don’t see the value of this line of thinking. A person can quit a job, get fired, take a sabbatical or retire etc. It confuses more than illuminates to speak of jobs as assets.

  • Posted by Alan von Altendorf

    I haven’t read through all the comments, but had to give a heads up on this one:

    “Small business loans mostly use capital given by the banks.”

    Wait a minute. Whoa. Business and industry are historically funded mainly by retained earnings, i.e., profits – not bank lending. Where the intermediaries are useful and add value is VC, underwriting new issues, mergers and consolidations of listed firms in a crowded sector. I agree with the post that asked what do we need these guys for?

    Right now, there’s nothing for banks to do except take deposits, clear checks, ration commercial and household credit for short term transactional purposes and hedge some foreign exchange. Honest to God, the one best thing the govt can do is cut spending and taxes, federal state and local.

  • Posted by Alan von Altendorf

    <>

    Way off base. Best thing that happened so far is the Lehman bankruptcy. Bidders came forward to buy Euro and Asian branches. That’s what should happen universally and why some in Conngress refuse to change the bankruptcy laws. Unless TARP is shot down, there will be massive shorting of Treasurys and a foreign buyers strike.

  • Posted by Alan von Altendorf

    Twofish wrote: “Your pocket is still going to be picked if there is no bailout, and unless you want FDIC insurance to fail, there is going to be a federal bailout of some sort. Right now we are looking at $700 billion to recap the banks, and FDIC only has $50 billion in cash.”

    Then bailout FDIC. [EDITED FOR LANGUAGE]

  • Posted by Murph

    Richard Cownie: “Given the pain of foreclosure and/or bankruptcy, I find it hard to imagine that more than 30% of homeowners will default”…

    Because of the structure of many of the instruments, the value can be well below ( 100% – Default% ).

    The investment banks (“grandpa, what was an investment bank?”) were pros at cobbling together instruments of equity- and junior-tranches and still securing “A”, “AA”, and even “AAA” ratings.

    Even for prime loans, the equity- and junior- tranches take the first losses, so, instruments composed of those tranches are very much at risk…

    And, recombine a few of those into a CDO^2 (CDO-squared: a CDO of CDO’s) and you truly have something which can very easily, at the end of the day, be worth absolutely nothing.

    A good indication that a high percentage of these instruments are basically worthless is that the banks have had a YEAR to offload these things and delever. The Fed did a good job of buying them time. The banks could find no buyers at any price which would not have revealed their basic insolvency.

    This points to Brad’s 33-cents-on-the-dollar figure being a good ballpark estimate.

  • Posted by bsetser

    Murph

    I agree with your basic point — namely the banks (including the former broker-dealers) had a year, and still didn’t onload the majority of this stuff. And I agree that combining risky tranches created structures that can have amazing little value – despite initial ratings.

    The 33 cents estimate tho was from Buiter — not me. I used it, so i didn’t think it was totally outlandish, but it would seem a bit on the low side as the average valuation for a $2.1 trillion pie. The outstanding stock of ABS is $4.4 trillion, and I have no good estimate of the likely current market cap of all of that. but not all of it will be the really nuclear stuff. At least i hope not …

  • Posted by bsetser

    alan — if I had to bet, there will be a foreign buyers strike if the TARP is shot down. Foreign willingness to hold the credit of US banks would plummet fast …

  • Posted by dieselm

    Warren Buffett invested $5B into Goldman Sachs today.

    For his cash, he received perpetuity preferred shares w/10% dividend, plus $5B more in options priced at 8% below the close.

    Can anyone here explain why if a bank like Goldman is stable enough for the world’s pickiest investor to put money in today, why we need to give $700 billion of taxpayer money for free, no strings, no dividends, no equity, no options?

    If Warren would up his investment to $7B, 99 more private investors like him and we’d be at $700 billion. Or we can give half of 2007’s personal income tax from every taxpayer in america to the banks for free.

    Outrageous. This crisis is a sham.

  • Posted by Murph

    Alan von Altendorf: “Business and industry are historically funded mainly by retained earnings, i.e., profits – not bank lending.”

    Respectfully, the vast majority of businesses doing $1 million or more (and many doing less) operate with a bank line of credit of some sort. And, the larger companies fund their day-to-day operations with commercial paper (about $1.8 Trillion which rolls over continuously).

    Very few businesses of any size could operate on a cash basis.

    Should the bank lines be terminated, and the commercial paper market freeze up, economic life would literally come to a standstill.

    As in a “hide in your bunker and hoard ammunition and canned goods” kind of standstill.

    I am not happy about the Treasury’s plan. I am not happy to be paying for the sins of others. However, we have to know what we’re facing on the other side of this…

  • Posted by Richard Cownie

    “Because of the structure of many of the instruments, the value can be well below ( 100% – Default% ).”

    Sure. But if the aggregate payment stream is still at 70%, then the aggregate value is still at 70%. If you’ve concentrated the risky tranches, then a lot of other stuff is pretty good.

    There must be a lot of stuff that will perform well – it’s just hard to tell which it is.

  • Posted by Cedric Regula

    Murph:

    “Should the bank lines be terminated, and the commercial paper market freeze up, economic life would literally come to a standstill.”

    Calm thyself. It’s not that bad. These are called commercial money market funds and it’s our savings and liquid cash that is providing the financing in the most efficient, low overhead way. I can do it with my Ameritrade account. All it needs is a clearing house and honest ratings of the paper.

  • Posted by Dr.Bubb

    ABOUT THE MATHS:
    http://www.greenenergyinvestors.com/index.php?showtopic=4292&st=60

    A GOOD START but i can see huge flaws in this analysis.
    It looks like Brad is assuming ALL of the banks mortgage exposure is worth only 33cents, not just the impaired/ subprime part

    WHERE have see seen falls of over 67% in house prices???
    AND that assumes there was zero equity in these homes in the first place.

    About 1/3 of Americans own their homes outright, and another big part have small loans, lets say under 50% LTV. Why should those loans be impaired at all.

    A lot of the junk debt secured by duff mortgages is outside the banking system, and
    those holders dont get the bailout, as i understand it

    Why not put together a pro-forma balance sheet on the entire US banking system, and then see what impact this plan could have, assuming the bailout funds are used to buy only the (undervalued?) illiquid mortgage backed bonds.

    BTW, how will the new agency sort out defaults when they occur to bonds they are holding? This is going to be messy work, and is not ideal for government bureaucrats, who are desk-jockeys, not problems solvers prepared to deal with individual homeowners.

  • Posted by Alan von Altendorf

    Brad, sorry about the language.

    Murph, if you want to argue that everything has changed in the past decade, okay, but for three centuries, banks have refused to fund new products and new industries. That’s what VC does for start-ups and retained earnings at established firms. Basic rule of corporate finance is to calculate NPV using a very high hurdle rate (opportunity cost of capital that could be deployed elsewhere). Not bank loans. Capital.

  • Posted by a

    Those who support this 700 billion proposal can provide zero evidence that it will help anything. Zippo. Zippo evidence that the world with the proposal will be a better, safer, more stable (add in your adjective) world than without it. The supporters play on fear – it’s the end of the world without it! – without seeming to explain that it improves nothing, so if it is the end of the world without it, it still is with it.

    Americans consume too much. When the system changes so that they cannot get car loans, it’s the system *working*. Trying to prop up the financial system so that the consumer continues to spend as usual, will only cause the system to break *somewhere else*, be it a crash in the dollar or a buyer’s strike of Treasuries or something else again, until Americans are not able to afford their cars. Pissing away 700 billion or more at this stage is the height of stupidity, and is far more likely to bring about the advent of moustached dictators than voting this proposal down.

  • Posted by Twofish

    Alan: Wait a minute. Whoa. Business and industry are historically funded mainly by retained earnings, i.e., profits – not bank lending. Where the intermediaries are useful and add value is VC, underwriting new issues, mergers and consolidations of listed firms in a crowded sector. I agree with the post that asked what do we need these guys for?

    I was talking about working capital. That happens in the commercial paper market through money market funds, and the people that run that are the investment banks.

    But anyway, suppose a VC gives you $15 million in funding. In the United States they don’t show up with an armored truck, they show up with a check, which you take and deposit in your bank account. If the commercial banks to under then this system falls apart.

    Alan: Right now, there’s nothing for banks to do except take deposits, clear checks, ration commercial and household credit for short term transactional purposes and hedge some foreign exchange.

    More or less, but if that system breaks down, then economic activity stops.

  • Posted by Twofish

    diselm: Can anyone here explain why if a bank like Goldman is stable enough for the world’s pickiest investor to put money in today, why we need to give $700 billion of taxpayer money for free, no strings, no dividends, no equity, no options?

    Because Goldman-Sachs is a very well run bank and doesn’t need a taxpayer bailout, and they aren’t the target of the bailout, and I doubt that they will get much if any funding from the government.

    The big problems are likely to be in the regional banks and some of the national banks whose names have come up in the news.

    So why is Paulson fighting for this if it doesn’t benefit his ex-employers. Well as hard as it to believe sometimes a politician will actually do something that they think is in the public interest.

  • Posted by Twofish

    Alan: Murph, if you want to argue that everything has changed in the past decade, okay, but for three centuries, banks have refused to fund new products and new industries.

    That’s intentional and a good thing. New products and new industries mean risk, and commercial banks have functions that are too important to put at risk. It’s a bad thing if *no one* funds these things, but there are VC and angel investors that are willing to put their capital on the line and take the risks. The main role for commercial banks is to make sure that the checks clear.

  • Posted by Twofish

    Cedric: These are called commercial money market funds and it’s our savings and liquid cash that is providing the financing in the most efficient, low overhead way.

    And last week, those came within a hairs breath of collapsing before Treasury came in and gave a FDIC-like guarantee to them.

  • Posted by a

    “And last week, those came within a hairs breath of collapsing before Treasury came in and gave a FDIC-like guarantee to them.”

    I see you read the New York Post.

  • Posted by Alan von Altendorf

    I would like to be shown that I’m wrong. Maybe it’s my skewed view of the world from Houston. Companies have cash. Capitalists like Buffett and Pickens have cash. FT says the S&P 500 have $500+ billion on hand or in short-term notes. Wells Fargo, JPM, Bank of America, Wachovia are well capitalized and solvent. So who’s in trouble? The brokers and hedge funds who placed OTC side-bets and leveraged x 30. They deserve to go out of business. Period.

    The crisis “will create a real winner takes all environment,” said Jason Trennert, chief investment strategist at Strategas Research Partners. “Well-run companies not dependent upon credit markets will take market share from companies which aren’t well run and are [dependent on credit].”

    http://www.nakedcapitalism.com/2008/09/corporate-america-sits-on-its-cash.html

  • Posted by John D Crowder

    interesting analysis but;

    No one seems to know anything “for sure”.

    Apparently all the King’s horses and all the King’s men really don’t know how to construct anything – only destruct.

    So let’s let “the market” play out this lethal scenario and take our hits when/where they occur.

    We may still have to face the music regardless of bailing out the losers.

  • Posted by flow5

    $700 bill to finance EXISTING property??? This has to exert a depressing effect on the economy.

    Why not $700 bill to finance NEW/REAL investment (plant & equipment), etc.

    Screw the gamblers.

  • Posted by Ben C

    There’s an article on SeekingAlpha which throws out similar numbers (http://seekingalpha.com/article/96826-do-paulson-and-bernanke-really-understand-what-s-going-on). The thing is, that article says many of the losses will come from non-subprime mortgages and corporate debt, which he estimates at 20 trillion with perhaps a 5% default rate.

    Is he just making up this 20 trillion number? It doesn’t seem to jive with your numbers. What do you think of his analysis?

  • Posted by bsetser

    the upper limit on outstanding mortgages — from the flow of funds — is $15 trillion. that is the sum of commercial mortgages as well as residential mortgages.

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