More on the Tell …

September 23, 2008 12:38 p.m.
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As we’ve been noting, a lot about the Paulson/Bush bailout plan only makes sense if you assume the US Government is going to be paying premium prices for worthless or near worthless securities. And Here Fed Chief Bernanke seems to be saying precisely that.

From MarketWatch

Federal Reserve Board chairman Ben Bernanke said that criticism of the $700 billion plan proposed by Treasury Secretary Henry Paulson overlooked a key ingredient: it is designed to avoid forcing banks to sell or value their mortgage assets at a “fire-sale” price. In a harsher tone than he has ever used in testimony, Bernanke spelled out the benefits that would accrue when the government can buy these mortgage assets at close to “hold to maturity” prices instead of the fire-sale price. Banks would have a basis for valuing the assets and won’t have to use fire-sale prices and their capital won’t be unreasonably marked down, he said. Liquidity should begin to come back to the markets and uncertainty should dissipate. Credit markets should start to unfreeze, he said. If the assets are purchased near the true hold to maturity prices, taxpayer losses should be minimal, he said.

As I read this, what we’re doing is taking a trillion taxpayer dollars to recapitalize these companies. The upside is that taxpayers break even if … and this seems like a pretty crazy if … these really are good investments rather than worthless paper. And the only issue is getting past this period of panic till they stabilize to the prices the taxpayers bought them for.

What am I missing?

Late Update: TPM Reader JR sends in this explanation …

Bernanke’s point is that for accounting purposes, banks are forced to write down their assets to market price. That causes a cycle of de-leveraging, in which banks try to increase their capital base by cashing in other assets, which makes their partner banks illiquid, in a cycle.

Bernanke is arguing that the government needs to make the market price equal the inherent value. Then, banks will be able to stop the damaging process of de-leveraging.

A well-designed auction can indeed estimate the inherent value.

But you’re right at the end – there’s very little upside for the taxpayer. Bernanke is suggesting that a well designed auction should minimize downside risk.

I think I’m saying the same thing as you, but I really think that you’re being too liberal in your description of these assets as worthless.

And TPM Reader EP adds this …

I saw your piece on Bernanke’s testimony regarding the mortgage bailout. The problem with fire-sale prices is that not enough liquidity will be freed up. A long term hold strategy works better and will probably help buffer against a radical downturn in the near future. However, I don’t agree with paying “hold to maturity” premiums for these assets across the board. Some of the real estate securing these loans are never going to come back, and I don’t think a 20-30 year strategy is in the best interests of this country right now.

The final number is somewhere in the middle between say, 25 cents on the dollar, and $1.50 on the dollar. Doing a loan-by-loan analysis to see where each loan balance falls in relation to an approximate value would take too long. Better to agree on a number – say 50 cents or 60 cents – that gives added liquidity, unloads the bad loans that are sucking up capital in analysis and collection costs, and lets banks lend more money.

I was at [major national bank] last year, and this year moved to [major national bank]. As a salesman I can say it has been extremely difficult to qualify borrowers for loans. Rates have not been very high, but downpayment, liquidity, and credit restrictions, plus the elimination of many of the awful loan programs (like stated income), have succeeded in weeding out bad borrowers. The good borrowers are waiting on the sidelines to see how much lower prices will go before committing to a loan. We are also requesting a lot more documentation from borrowers to prove what they say in the loan application. Appraisers are isolated from the sales process. These are all good things, even if they are a little bit of an over-reaction.

I think the bailout plan, modified with Dodd’s suggestions, will work, so long as oversight is ongoing, and bank management is given enough incentive financially to keep up the recovery process. Penalizing bank management is counter-productive. A punishment will just send many otherwise intelligent people to move on, leaving the mess with less-qualified people to manage.

I don’t normally like printing so many emails stacked on top of each other. But I’m finding a lot of these very clarifying. So I’ll add TPM Reader JL‘s note too …

I just saw your post “More on the tell …”. Let me try to explain Bernanke’s thinking. I’m a little puzzled by the exact language the Marketwatch article attributed to the Fed chief, but I’m pretty sure I understand his logic. (FYI, I spent over a decade with a company that services the securitization industry, so I have some background here.)

The bulk of the assets that the Treasury would buy under the Paulson plan are the highest rated “tranches” of subprime bonds issued between 2005 and 2007. These bonds sit above other, lower rated bonds in the capital structure of the relevant securities. To simplify, you might have a pool of $100 million worth of subprime mortgages used to issue $70m in AAA bonds and $25m in let’s say BBB bonds. The remaining $5m is “overcollateralization.” As mortgages default, the overcollateralization begins to disappear. Once that’s gone, the BBB bonds get hit. Meantime, principal being repaid by the borrowers who aren’t defaulting is used to pay back the AAA bondholders. The math gets really complicated, but suffice it to say that the $30m in cushion provided to the AAA bondholders allows them to withstand very high default rates. The typical 2006 AAA subprime bond was able to withstand a cumulative default rate of 50% or so with recoveries of around 50%. Cumulative default rate just means what percentage of borrowers from the original pool end up not paying. Recoveries means what percentage of the loan is recovered on foreclosure. At this point, it looks like cumulative default rates may be somewhat higher than 50% and recoveries may be somewhat lower than 50%. So, the AAA bondholders are probably going to suffer some principal losses. The question is how much. (By contrast, a lot of the lower rated tranches are certain to be wiped out … but the Treasury won’t be buying these.)

Right now, these formerly AAA bonds have a market price of around 50 cents on the dollar. To justify that price, you’d have to have going forward cumulative default rates of something like 80% to 90% with recoveries of around 30%. The math is complicated, but I believe that’s what it works out to. That is a really, really extreme scenario and probably entails very dramatic additional declines in housing prices (say 30% down from here).

I think Bernanke and Paulson’s logic is that they can go in and buy these bonds at, say 60 cents on the dollar. The sellers would not have to take any further writedowns. And, the Treasury by holding the bonds to maturity would most likely collect more than 60 cents on the dollar based on some number of mortgagees continuing to make payments (believe it or not, most of them still are) and the proceeds from foreclosures.

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