Subprime fallout a small mess in a big economy

It says something about economics, and about the breadth of our economy, when the presidents of two Federal Reserve Districts – Dallas and San Francisco – come up with such different assessments of the situation.

This past Monday, the Dallas Federal Reserve Bank’s President, Richard Fisher, said that “our economy appears to be weathering the storm thus far.”

On the same day, in a speech given in San Francisco, Janet Yellen, the Federal Reserve Bank’s President there, said regarding the effect of housing on the outlook for aggregate demand, “I see significant downward pressure.”

The reaction to these divergent assessments probably says more about human nature and about the news media than it does about the economy. Financial markets took Yellen’s words to heart and securities prices dipped substantially. They ignored Fisher’s more positive outlook.

The market overreacted, of course, as it always does. In all likelihood, both Yellen and Fisher are right. Depending on what part of the United States you are in, the effects of the housing market deflation and the subprime credit crunch can be either right in your face or hard to find. A review of recent economic assessments by the twelve Federal Reserve Districts reveals significant differences in economic activity and prospects.

The U.S. economy is very big, and by comparison, the subprime mess that Wall Street has gotten itself into is quite small. Subprime mortgages represent, at most, between 10 and 15 percent of the mortgage market. And of these, no more than 10 to 15 percent are in trouble. So, the messy portion of the mortgage market is somewhere between 1 percent and 2.25 percent of the total.

Even that amount, of course, overstates the portion of the market that is actually “at risk.” The underlying collateral – the houses – are still there, and when the dust settles most will be sold for at least three-quarters of their mortgaged value.

In real terms, then, the total mortgage market stands to lose somewhere from one-quarter to about one-half of 1 percent of its value. This is an amount that a solid, blue-chip equity stock might lose in an hour’s trading without causing an eyebrow to be raised.

So why, then, do we have otherwise rational people predicting dire consequences, even global recession because the subprime market is tanking?

The answer is probably in our human nature; more specifically, in two separate aspects of our human nature.

The first is our preference for bad news over good. The news media is often criticized for its fixation on bad news -justifiably, in my opinion -but it is probably more about us than it is about them. While the news media deserves no credit for pandering to our weakness for negative news, they couldn’t do it effectively unless our underlying nature supported the demand for the stuff.

The mental scale on which we weigh negative and positive news is probably a survival mechanism embedded deeply in our brains. Human beings have always lived on the edge, in an environment where more things can go wrong than go right. Good news was scarce and could be savored, later, by the fire. Bad news represented an immediate threat.

It is not surprising, then, that it is so easy to magnify the effect of a market glitch like the subprime credit fiasco. The news media made its contribution by reporting such things as mortgage defaults in percentage terms, in order to magnify the headline effect. A tiny number, when doubled, remains a tiny number, but the headline still roars, “Defaults Double.” But, at bottom, it was us, not the news media, who wanted to hear the worst.

The other aspect of our human nature involved in the subprime situation is less attractive. Many of us tend to behave very badly when our mistakes are discovered. In the wake of the bad news about subprime mortgage loans, many banks, securities firms, analysts, and credit rating organizations have all been found to be either duplicitous or dupes – not a good choice – and have overreacted in almost tantrum-like fashion.

We know that, given the actual size of the subprime market, the best thing for the economy is to just get past it and move on. The problem for Federal Reserve Chairman Bernanke is the mismatch in time lines.

The psychological response of the market is nearly instantaneous while the housing finance market, by comparison, is this great lumbering tortoise. Because of the Slowski pace of the housing market we are still probably months away from the end of the bad news. And until then, the Fed will have to try to hold the market together to keep its tantrums and its appetite for bad news under control.

James McCusker is a Bothell economist, educator and consultant. He also writes Business 101 for the Snohomish County Business Journal.