Posted on 09/22/2008 4:54:27 PM PDT by Praxeologue
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.
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