Why the Rescue Plan Can Work

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 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.

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.

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 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%.

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 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.

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.

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.

The U.S. government is likely to make a profit from these actions.

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.

I know what you mean. We paid off our house last fall, and have a retirement nest , but that looks a bit skimpy in the face of all this foolishness. I moved all my investments off shore last April. I have absolutely no position whatsoever in the US financial system.

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.

It is not a class thing

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.

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.

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.

If they can’t trick the state into building a stadium for them

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.

Bank failures alone can cause a depression, and a huge one. We can lose nearly all of them in a very short period of time. That isn't easily recovered from, and it really isn't worth going there.

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, 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.

If these investments were ultimately going to make someone a big profit would the lending institutions be so eager to offload them?

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:

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!)

it stretches credulity to suggest that Paulson is "panicking".

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.

The pricing which set up this mess was never normal to start with

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

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