by Tanta on 7/13/2007 07:41:00 AM

Yes, I mean utter worthlessness. I have seen one or two unhelpful Fed Letters in my time, but this one, "Comparing the Prime and Subprime Mortgage Markets," brings a remarkably shallow grasp of the subject to bear on a perfectly vacuous thesis in order to produce three and a half pages of tripe. If this is the sort of advice the Fed Banks are taking from "economists," then no bloody wonder we're in trouble.

Here's how it starts:

We show that the subprime mortgage market is facing substantial problems, as measured by delinquency rates, while the prime mortgage market is experiencing more typical delinquency rates, i.e., at historical averages (see figure 1). Within the subprime mortgage market, we observe a substantial increase in delinquency rates, mostly for adjustable-rate mortgages (ARMs). Since the subprime ARM market is less than 7.5% of the overall mortgage market and a vast majority of subprime loans are performing well, we believe that the subprime mortgage problems are not likely to spill over to the rest of the mortgage market or the broader economy.

That's it. In three and a half pages, the authors demonstrate that subprime ARMs are the segment performing at worse than "historical" rates of delinquency, and that they are indeed 7.5% of the outstanding mortgage book. What we never get is a statement of what it might mean for "subprime problems" to "spill over to the rest of the mortgage market or the broader economy." What, exactly, does that mean? Is the implication that the "subprime problem" could "spill over" if it were only a bigger piece of the mortgage pie? What, exactly, would be the mechanism of this "spill over"? If you guessed that it might have something to do with declining MEW and downward spirals of home values due to subprime foreclosure waves, you might have a point, but neither of these issues is raised in the Fed Letter. Apparently, on Chicago Fed's planet, things just "spill over" when the bucket gets full enough of delinquencies.

The whole thing is littered with irritating mischaracterizations of both mortgage lending practices and recent so-called "bailout" initiatives, the latter of which involves throwing around some numbers ($20 billion from Freddie Mac, a billion from Citi and BoA) without offering any analysis of how far that goes to sort out the $1.5 trillion in subprime loans on the books. You get this level of analysis on Bloomberg (and you get it more timely).

Dear Chicago Fed: we're all really tired of rehashing sound-bites. How about you using the institutional smarts you have to answer some interesting questions for a change? Such as: how did we get so many subprime borrowers in the first place? Do states like Michigan and Indiana have high rates of delinquency and default because of employment woes, or high rates subprime originations because of employment woes? Is it possible that the "historically" low rate of prime mortgage default exists because subprime has been available to accept the "spill over"? What happens when the lender of last resort goes away?

Look, there are two reasons why the default rate on prime loans is as low as it is. The first, obviously, is that decent credit standards in the first place limit the number of loans that experience delinquency. The second is that, historically, there has been somewhere for those loans that do experience delinquency to go: either a voluntary sale of the home that covers the loan amount or a refinance into a subprime loan. The existing home market and the subprime refi market are the "spill overs" of the prime mortgage market. To discuss the question of "prime contaigon" without reference to existing home sales or refinance opportunities (by price and by credit standard tightening perspectives) is, indeed, utterly worthless.