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.

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.

Sorry, you don't get it. First, they didn't purchase these securities. They received them from bankrupt counterparties who defaulted on bank loans to these banks. They were the only available collateral for bank lines of credit, which the previous owners drew on after their previous lenders in the commercial paper market pulled the plug on those previous owners.

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?

I have nothing but respect for Friedman, and I understand that the deflationary period, or the “bust” part of the cycle, is when we feel the pain. But the best we can hope for is a sort of Faustian bargain. Either we have deflation and precipitous economic collapse, or we have more inflation in the hope that buying time will prevent total collapse. Because the immediate collapse of our currency is unthinkable, I do not advocate allowing banks to fail willy-nilly. However, that does not mean we don’t have to have some sort of deflation. Bad investments must be liquidated, and people must be encouraged to switch from consumption to saving. We also have to be careful not to debase the currency too far in our effort to prop the currency up.

This debate has always seemed to me like debates over limiting the state to the express powers of the Constitution. Wouldn’t we all like to live under the rule of law? Wouldn’t it be great if we could dismantle the welfare and regulatory superstructure that prevents us from being as productive as we could be? But aside from the fact that politicians are by definition incapable of standing athwart the expansion of the state, there is no way we can dismantle every addition to the federal government since the Civil War. Doing so would lead to the sort of calamity that results in revolution. It would confuse the people too much.

Likewise, I regret the amount of control that the central government exerts over our money. However, to attempt to liberate money from government-inspired inflation, and to reinstitute a free market, would be disastrous to the economy. It doesn’t much matter that it’s their fault that it’d be disastrous, the fact remains. I don’t like our monetary policy any more than I like a “living Constitution.” I’m not naive enough to think anything can be done to rectify things.

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