Posted on 09/22/2008 4:54:27 PM PDT by Kennard
Why the Rescue Plan Can Work>
Last Update: 22-Sep-08 08:21 ET
The government plan to buy mortgage-backed assets from financial institutions is likely to be a win-win. It will be a win for financial institutions because it would finally provide a legitimate buyer for mortgage-backed assets. It will be a win for the government because these assets are trading well below their intrinsic value. The government could make a large profit.
The Crux of the Problem
The essence of the problems plaguing the U.S. economy (as discussed in the August 18 Big Picture column) is housing.
The impact, however, is not as often presumed. There has been only a marginal impact on economic growth and on consumer spending.
Real (inflation-adjusted) GDP has risen 2.2% over the past year. If the impact from housing is excluded, real GDP was up 3.2%. In other words, reduced spending on housing took 1% off real GDP growth.
The weakness in the housing market has not produced negative GDP growth, nor has it induced a pullback in consumer spending.
In the past six quarters, real consumer spending has been up at an annual rate of 3.9% in the first quarter of 2007, followed in subsequent quarters by annual growth of 2.0%, 2.0%, 1.0%, 0.9%, and most recently by 1.7% in the second quarter of this year.
Lower home prices have had a dampening effect on consumer spending, but nothing approaching a crisis.
The crisis affecting the stock market is directly related to the valuation of mortgage-backed assets held by financial institutions.
An Improperly Functioning Market
Many, many financial organizations hold mortgage-backed assets. Mortgages made by banks and other financial firms were commonly sold to Fannie Mae and Freddie Mac. These organizations packaged them into debt instruments backed by the mortgage payments of the individual mortgage holders.
The value of these securities started to decline in late 2007 as mortgage default rates began to rise.
The decline in price of these assets was rational. The reduced price reflected an increased likelihood that some of the income to the debt holders would not materialize.
Then the roof caved in.
Holders of these mortgage-backed securities were forced to write-down the value of these assets on their balance sheets. That caused large losses and weakened capital positions.
These holders of mortgage-backed assets, however, represented the vast majority of the firms buying these debt instruments. As banks and brokers got hit, they became understandably less willing to take on additional mortgage-backed assets.
The demand for mortgage-backed assets collapsed, and prices plummeted further. A vicious cycle developed of write-offs, lower demand, and a further decline in price.
The mortgage market is a huge, huge market dealing with hundreds of billions of dollars of assets. Yet, suddenly there were no buyers.
As a result, the prices of mortgage-backed assets in the secondary market dropped below their true, intrinsic value.
The "true" value of these mortgage-backed assets is the current discounted value of the future income stream produced by the mortgages.
By any reasonable calculation, these securities are trading well below this intrinsic value.
(An illustration of the math is presented below, but for those wanting an outside opinion, please see this article from The Wall Street Journal in which the Bank for International Settlement (BIS) concludes that the indices used to determine MBS prices were inaccurate because of the illiquidity in the market and risk factors for major buyers).
The Math
The national foreclosure rate on all mortgages was 2.7% in the second quarter, according to the Mortgage Bankers Association. The percentage of mortgages with one or more late payments was 6.4%.
That means that 93.6% of all mortgages (including subprime) were current.
If the average mortgage rate on a package of loans is 5%, and even assuming that all delinquencies are going to lead to foreclosure (which simply won't happen), then 94% of that 5% income stream equals a 4.7% return. And that is just on the interest payments. There is an equity portion in the majority of mortgage payments that provides a return of capital.
A 5% return in the first year on the full face value of the debt instrument gives the MBS value. Even assuming significant further increases in foreclosures (the above example suggests that foreclosures will triple to 7% almost immediately), the math implies a decent income stream for years to come.
The data above are general because each MBS has to be evaluated separately based on the mortgages held.
Nevertheless, the ABX index for AAA is at $0.50 on the dollar, and that for subprime at less than $0.10 on the dollar.
This is despite the fact that mortgage default rates on AAA debt are less than 1%, and for subprime 12%.
It simply doesn't make sense for subprime mortgages, which have a 12% default rate, to trade at $0.07 on the dollar. That means that 88% of the mortgages are not in default. Even if only 70% are current, the return on those mortgages is probably close to 7%.
Yet, a basket of mortgage-backed securities was sold by Merrill Lynch to a hedge fund not too long ago for $0.22 on the dollar.
Depending on the mortgages in those securities, that hedge fund may well reap the entire $0.22 within the first three or four years. If foreclosure rates don't rise sharply over the very near term, that hedge fund will make a killing.
The lack of liquidity in the secondary market for mortgage-backed securities has created huge mispricing conditions that create massive opportunities for able and willing investors.
Why should hedge funds be the only ones able to prosper from this? Why not the U.S. government?
The "Bailout" Concept
The U.S. government has now proposed to buy $700 billion or more of mortgage-backed securities.
This should not be termed a bailout, even if it has the effect of helping financial institutions.
The government is buying assets that provide a current income stream -- a good income stream. It is in effect an investment.
In fact, it is an investment that could prove extremely profitable for the U.S. taxpayer, even if the government never sells a single security back in the open market.
If mortgage defaults do not rise appreciably, these securities will reap a huge profit.
What it All Means
First, let's start with what the government proposal does not mean -- it does not mean the stock market will go up right away.
However, the proposal does go to the crux of the problem in the U.S. economy, and more particularly what ails Wall Street.
It will restore liquidity to the secondary market for mortgage-backed securities. This will restore reasonable pricing. That in turn will lead to a stabilization of the vicious cycle that was leading to excessive write-offs at financial firms.
This will, quite appropriately, help earnings at financial firms.
In addition, despite all the hand-wringing and demagoguery that will accompany this proposal, all the government is doing is buying securities at a deep discount. These securities will provide a steady income stream that will, over time, more than offset the cost.
The U.S. government is likely to make a profit from these actions. (As occurred with the Chrysler "bailout" and as may well occur with the government ownership of Fannie Mae in the long term in that more appropriately described bailout).
This plan is likely to be a win-win that over time returns stability to bank earnings and thus, provide a boost to financial stocks.
This article is intended to explain why the rescue plan is not the horrendous burden to taxpayers and government finances as it is too often described. By itself, this plan is a positive for the stock market.
There are still other problems that the market faces, however, and as we have consistently written, it will take more time for the market fears to settle down and for the stresses in the financial system to work out. Nevertheless, real growth continues. Inflation has eased. Nonfinancial corporate earnings growth is reasonable.
The patient investor will find opportunity in this mess, just as the government is now in effect doing.
--Dick Green, Briefing.com
Problem is you are dead wrong - it didn’t happen on a “republican watch” - Remember who has been in charge of the House and Senate the last 2 years? Remember who dreamed up the CRA? Remember who has been protecting Fannie and Freddie from any investigations or even basic oversite functions?
McCain is throwing us under the bus.
The housing bubble has not caused a recession. I have no reason to believe it alone could cause another Great Depression. What could cause a depression is pumping more credit down the sinkhole. You do not recover from a speculative bubble by expanding credit. That’s like trying to extinguish a fire by throwing more fire on it.
“The U.S. government is likely to make a profit from these actions.”
Oh boy. Does that mean they’ll stop taxing us and just invest money they print from now on?
The Masters of the Universe have leveraged us into oblivion.
Paying taxes to bail out failed banks is the patriotic thing to do. LOL
I wonder about this myself.
If the market can say these things are worth full price and be wrong, it is entirely possible that the market can say they are worth 22 cents on the dollar and be wrong.
Very possibly, the guys who paid 22 cents to Merrill Lynch will make a handsome profit.
The problem with the government buying them is that they’ll be too soft-hearted to realize full market value by throwing out the existing mortgagee and selling the property at a market-clearing price.
Yes, of course. But the business people I have spoken to today, real estate developers, are "offended as taxpayers" by this "bailout of Wall Street types". One said "If I am upset, how do you think a the little guy feels." McCain needs to to out there helping the avaerage person understand what is happening. It is not a class thing, but that is how many are seeing it.
Which is why McCain must win. Otherwise this will become a left-wing slush fund for the next twenty years.
Which is why McCain must win. Otherwise this will become a left-wing slush fund for the next twenty years.
If these investments were ultimately going to make someone a big profit would the lending institutions be so eager to offload them?
Instead of a bailout wouldn't they be content with a bridge loan to get them by until the big profits start rolling in?
Let's be honest - congress and the wall street fat cats have run our financial system into the red and this is nothing but a scam to bail them both out.
There is no pot of gold waiting for taxpayers - in fact, if some serious changes aren't made the only thing waiting for us down the road will be another bailout.
Instead of crafting plans to do congress's dirty work for them President Bush should be publicly pressuring them to make changes to stop the hemorrhaging and to remedy the problem without giving away money our children and grandchildren will be earning.
Buahahahahhahahha!
A win -win to the tune of about $24,000 dollars per US taxpayer ( those of us who actually pay taxes.)
Yep! Thats a real win all right!
I haven't paid a cent yet and already I want my money back!!!!! I'll take stock from AIG for bailing it out, thank you very much.Issue the shares in my name: John Q. Public.
The people you are talking to just had their toys taken away, and they need to blame someone. They're not helping, you know, because they were just as much part of the problem as those evil "wall street types".
Bottom line: I have to contribute at least $7000 to this bailout.
F that S.
When I paid the last payment on my house I thought I was done. Boy was I wrong.
It won't, but demanding that Wall Street take another $700 billion hit, even in the short term, on top of the $500 billion they already ate over the last year, will. It won't cover the (quotational) losses, either. We still eat those.
When Lehman failed it brought down larger banks within days. Each of those was doing the same to the next couple. A run had already started on money funds, at a rate of $160 billion per day. Nobody has that kind of liquidity. Nobody. The Fed either makes it or every bank fails.
And that would (1) still leave us with the loss, wearing out "taxpayers funding the FDIC" hat. Or we could repudiate that too, and then (2) we still take the loss, while wearing our "depositer" hat.
This isn't about housing any more. It is about whether the beggar thy neighbor to heck with them all attitudes so far deployed to deal with the housing bubble bursting, are allowed to destroy the US financial system, or not.
But we take the hit, regardless. Nobody else has it. There is no blood in stones.
“But we take the hit, regardless.”
You’re right. Bad investments simply must be liquidated. My point was that there’s no reason to assume a Great Depression need follow. If the credit contraction is swift and short, we’ll recover promptly. If we throw more money at the problem, we’ll make things worse. The bubble-burst alone cannot cause a Great Depression. bank failures alone cannot cause a Great Depression. Not allowing the market to correct itself will.
....and I guess the Martians are going to bail out the US gubbmn’t?
Idiot is talking out his donkey. The essence of the problem is a perfect storm of highly leveraged debt, with a even more leveraged provided through a tightly interlocked system of derivatives to ensure that a snowball in one sector turns into an avalanche that takes down the whole mountain. That is why Bernanke and Paulson are panicking, and not because some folks might lose their homes.
People keep forgetting that the guys on the other side of the table on this deal are professional traders. Suckering the other guy out of a few points or a few percent is what these guys do. IF they are offering you the deal of a lifetime, it is because it will be the deal of a lifetime - for them - if you take it.
If there was a profit to be made proportionate to the risk these guys would have their own money in it. They have already raked off the profit. This is just about passing on the business about patiently waiting to get some of your money back. That is what these guys do for a living.
Woah. You sound rich to me. Now you get to buy my house for me.
Its all invested in stable foreign bank stock, in banks where they actually ask borrowers to verify how much they earn per year before lending money out. Their stock is off about 10% but nothing as serious as most US banks who drank the liberal Kool Aid, ( instead of a lobster in every pot, it was a house in every pot).
“This is just about passing on the business about patiently waiting to get some of your money back. That is what these guys do for a living.”
It’s just like baseball and football team owners. If they can’t trick the state into building a stadium for them, they nonetheless magically gather up the money.
The bailout plan is socialism. Do we or do we not believe in conservatism? Seriously.
I see Paulson and his friends feeling so badly about this that they are writing checks and donating some of their own personal take from all of the runup to the Treasury. We are all in it together.
To me, it stretches credulity to suggest that Paulson is "panicking". Perhaps you are right, but ... as former head of Goldman, Paulson must have know how these pieces fit together and how they would react/interact in a crisis. Put another way, if Paulson didn't know, then it was all beyond human compehension.
I had a friend who had a venture capital group that used to put these kinds of deals together. I liked him personally, but my view of the immorality of this put a strain on the relationship.
We should buy the dodgy paper clean, no riders and no strings on any of it, liquidate the collateral ruthlessly on any portions not paying, repackage and resell the rest with all the non-performing loans stripped out, and move on.
“Bank failures alone can cause a depression, and a huge one.”
You mistake cause and effect. Depressions most often result from credit expansion (unless there’s a plague or something). Bank failure is a sign that credit is contracting, which itself is a sign of recovery.
Tie that present with an energy bill which allows everything with lease fees and taxes as usual—drilling everywhere, nuclear, refineries being built, natural gas for trucking, solar panels on public facilities like schools, etcetera—and you have a respectable fix.
NO BAIL OUT!
“No, I just know actual financial history and don’t buy your old line of Misesean bilgewater, is all.”
What do you think causes the business cycle, then? Underconsumption? The rythms of nature? Greed?
Mmmmm, bilgewater.
McCain couldn’t be more wrong on this issue. He needs to repudiate the bailout plan and get on the right side of this or he’s gonna lose fiscal conservatives.
Regular folks who take care of their finances, didn’t make or take any of this risky paper, and worry about the fiscal future of this country are not gonna vote for McCain if they don’t see a difference between the candidates.
And at the moment, on this issue, there is no difference.
Damn good question.
And in some cases, what is being bailed out, is no sort of asset, but merely derivates - bets placed which failed.
This bit of the article makes me mad:
It will restore liquidity to the secondary market for mortgage-backed securities. This will restore reasonable pricing. That in turn will lead to a stabilization of the vicious cycle that was leading to excessive write-offs at financial firms.
This will, quite appropriately, help earnings at financial firms.
Reasonable pricing? That is never attained by govt action, it is set by market forces - no matter how painfully. The pricing which set up this mess was never normal to start with, so cannot return. It was excessive because of a bubble, caused by lax lending and excessive liquidity.
A week ago Paulson was saying everything was `blue skies; today he says he’ll `buckle’ for the right of the Masters of the Universe (MOU) to their stock options, bonus pay, perqs, etc.
It’s good to know we have this informed & candid advocate fighting for us taxpayers....(Wow, Joy Behar is on larry King and I think she tried the brown acid!)
Bets placed to take more profit off the table than was on the table and stick someone else with the loss.
Well let me adjust my gerunds to account for your sensibilities and suggest that Paulson and Bernanke feel a sense of urgency in stepping out on this. Therefore, they are working hard to instill a sense of panic in everyone else to write him a blank check without taking the time to think through the deal. Remember, in Paulson we are dealing with the world's smartest trader, and he is going to do his best to keep as much on his side of the table as possible. He has only been doing this for 40 years so he ought to be a master at it.
That is the problem. Leveraged real estate debt seeking double digit appreciation became a self-fulfilling prophecy. My favorite indicator is the average housing prices in Scripps Ranch, San Diego. This is a good upper middle class neighborhood, nice area, but nothing extraordinary, hard working folks with some high end housing. In 2000 average price was about $240K, IIRC. At its peak it hit $700K. Of course incomes did not increase to pay for this. But there are mortgages let on the $700K, probably no down, liar loans on property that would probably have appreciated to $300K through "normal" appreciation, if that. So if we slide back to just reasonable prices someone is out $400K. The "owner" is out some rent checks and the postage stamp to send the keys to the bank
I asked:
“If these investments were ultimately going to make someone a big profit would the lending institutions be so eager to offload them?”
You answered:
“Yes, they would be eager to off load them, because anyone carrying them has to pay 12% and upward to borrow money. And not one financial institution is solvent with that kind of cost of capital. You can’t borrow at 12 and lend it at 6 and make it up on volume.”
So really, your answer is:
“Yes, that’s a definite NO. Because they would not make big profits on these bad investments due to the cost of capital.”
And that is why they are called “illiquid” (new buzzword - has a nicer ring to it than “bad debt” or “foolish investment”, doesn’t it?), and that is why they are so eager to unload this garbage on taxpayers.
Not to mention that no one even knows what security or real property is behind this bad paper. A lot of it is derivatives two or three times repackaged from the original transaction.
And what kind of knowledgeable investor doesn’t take the cost of their investment capital into the equation when calculating the value of a securities purchase?
I’ll tell you - it’s the kind that expects to drop their bad paper on the government.
Thank you for peeling another layer from the onion.
And the cost of capital of the major banks then stuck with it, is not a fixed item, but exactly the variable whose movement *is* this crisis. Last year, major wall street banks could routinely borrow money for 5% to 6%. That was approximately where short term rates were, at the top of the Fed's tightening cycle. Since then the Fed has cut short term rates to 2%, but the interest rate on these bank's notes and bonds outstanding has jumped to double digits. 10% for some, 14% for others.
The phenomenon is known as "discredit" in the historical literature of bubbles and their aftermath. People become unwilling to lend to a tainted institution, except at exorbitant rates, and those rates themselves render that institution unprofitable. It is fear of getting stuck with losses that causes this, of course. But that fear is a self fufilling prophecy - if the rates a bank can borrow at are driven high enough, none is profitable.
The reason the commercial banks are still standing and the investment banks have all been destroyed, is the commercial banks fund themselves mostly through deposits, which being FDIC insured, can still be raised at 3% rates (on CDs etc). Even the commercial banks are paying high rates on the remainder of their capital, however - their notes and preferreds are yielding 8% to 9% right now. Since those are only a fraction of their total funding cost, though, they are around break-even lending at 6% or so. If, on the other hand, they pile into treasury securities seeking maximum safety and liquidity, they earn only 1-3% on the credit side.
Every financial institution is fundamentally a credit rating. They need to be able to borrow more cheaply than they lend, long term, or there is no economic reason for them to exist. After their failure to forsee or predict the blow up in mortgages, no one in the past year has trusted ratings from agencies. As a result, A rated corporates yield 12% in the finance sector, and 10% in the real estate sector. Simultaneously treasuries are well bid at 2%, and utilities or other industrial companies can borrow at 5% to 6%.
These spreads are unprecedented for top rated companies and for financial companies. They are what would be normal in a down part of the cycle for junk bonds, where a third are expected to default within about 5 years. That was the bond market expectation over the past year, and it will fufill itself if sustained.
The banks all follow ABX indices, which are benchmark bundles of mortgage backed bonds, tiered by initial credit rating and divided up by time of issuance. Those deals entered into in the first half of 2007 are the worst of the bunch, those in both halves fo 2006 nearly as bad. Few were done after that. In the worst period the quotations dropped to 50 cents on the dollar for the AAA rated senior tranches. The lower ones, nearly worthless.
Fundamentally those are forward looking bets on the scale of losses that will be experienced on residential real estate, peak to trough. They are trading like put contracts on house prices. Darn near it. The underlying assumption behind the pricing seen, is that everyone underwater will mail in the keys, and that in addition each workout will cost on the order of 30% of the initial loan amount, to deal with legal costs of foreclosure, listing, maintenance, realtor fees, and commission etc on the resale. That, in addition, the peak to trough decline in house prices will be on the order of 40%. Maybe 50% in the areas with the larger price run ups in the bubble.
Those are very conservative assumptions, but they are what the secondary market reflects. At the same time, since A corporates with finance risk are available yielding 12-14%, the rate of discount required to hold such paper has soared to those levels. So you have things that may be worth 40 cents or may be worth 70 for the best tranches - eventually - but then they are discounted to yield 15% or more. On those terms, a few vulture investors are interested.
Understand, though, the usual buyers of this sort of speculative debt all went bankrupt last summer and fall. They owned this stuff in the first place, with leverage. They can't buy it now, they already blew out. And banks aren't going to lend a dime to anyone investing in it. They got here by that heads we win, tails you lose game and they are not eager to repeat it. Therefore, no one can borrow money to fund new investments in this stuff. It would have to be pure equity financing, from players previously on the sidelines.
While a few mortgage funds were created for that sort of thing in the first half of this year, the amounts are piddling. The private equity types (Lone Star e.g.) have taken up more of it. Meanwhile, every leveraged gunslinger in the world was instead betting the farm on the "end of the world" trade.
Which consisted of shorting financials and the dollar and going long commodities. That is where all the offshore risk money has been - not looking to buy up this paper. The alternative investment you needed to compete with peddling it, was "short Lehman with 90% borrowed money".
That is the reality of the thing.
Now, objectively speaking this huge spread is arb-able. I mean, you can short treasuries and buy corporates and earn the spread between them on zero capital, as long as the corporates don't actually default. Why hasn't that been the profitable trade?
Because the banks have been doing the reverse - dumping their corporates regardless of cost and piling into treasuries. Why? Basel II capital adequacy standards, pretty much. Huh?
When a bank holds a US treasury, it needs no reserves against it for possible losses. When it holds a corporate bond on the same amount, it needs 8% of the value of the bond, minimum, set aside as a reserve. Risk adjusted assets are the denominator and capital the numerator of the most widely watched indicator of bank strength.
If you lose half your capital in mortgages, even only a paper write down, your risk measures are going to soar and stick out and say "short me" among your competitors. But if you respond by moving an equal amount from corporates to treasuries, voila, your risk drops, your capital required drops, and your tier one capital rating remains its robust former self. Of course, your earnings drop - treasuries aren't paying much in the way of interest. And corporate rates go up. But that is collective action for you.
The first bank to stop playing that game and go long risky corporates in a big way might have made a killing. Or might have seen its tier one capital fall by half and the sharks gather and been killed. Wanna bet the bank?
IT WILL BE A WIN FOR THE FINANCIAL ESTABLISHMENT AND FOR GOVERNMENT
//////////////////
No mention of the People
Remember of by and for THE PEOPLE.
KILL THE BAILOUT
A week after the election, there will be a nationwide bank shut down and troops will be in the streets - regardless of who wins.
Mark your calender - November 11.
Interesting post, but disconcerting that you view long-term losses on non-performing mortgage loans to be in the range of 40% to 50% of face value. Contrary to my post to you on another thread, that makes likely (net) losses $1++ trillion. Staggering.
Based on your understanding of bubbles, I am probably not alone in being interested to know what role you believe government should play, and not play, in regulating the capital markets, both on an ongoing and extraordinary basis.
This is HS (BS with malice). These guys packaged and sold the stuff in the first place. If they got it back from the guys they sold it to, well, what goes around comes around.
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