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  • From: bob ford <bobford79 AT yahoo.com>
  • To: homestead AT lists.ibiblio.org
  • Subject: [Homestead] bailout -- another take
  • Date: Sat, 4 Oct 2008 10:26:11 -0700 (PDT)

Europac sells a service, but I thought this was decent all-around commentary

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October 3, 2008

Liquidity is in Eye of the Holder


We are being told loudly and repeatedly that the gargantuan mortgage bail-out
package is necessary because illiquid mortgage-backed securities are clogging
our financial arteries, threatening the economic equivalent of cardiac
arrest. The idea of the plan is to transfer these supposedly valuable, but
currently unmarketable, assets to the government so that private institutions
can freely lend once more. The monumental flaw in this argument is that the
mortgage backed securities are in fact highly liquid, just not at the prices
the owners would like to receive.

Mortgage bonds are just like houses. They won’t sell if the owners stubbornly
refuse to drop the price. However, they can find buyers if they acknowledge
reality, and lower their expectations accordingly.

The government tells us that if these assets are held to maturity their full
value will eventually be realized, and that it is only because of a lack of
current liquidity that their value is not reflected in the market. However,
as many private transactions have shown us in recent months, these assets
will find buyers at the right price. These are not overly exotic assets but
relatively straight forward mortgage obligations. The inability to find
buyers is not a function of liquidity but simply of price. The government is
seeking to “create liquidity” by overpaying.

The government’s assumptions about the “held to maturity” value of these
mortgages completely understate the likelihood of widespread default. Some of
the “illiquid” assets represent tranches of mortgage-backed securities that
will be completely wiped out. Even the higher quality tranches will suffer
severe losses due to mortgages that will inevitably go bad.

For example, take a $500,000 adjustable rate mortgage on a condo in Las Vegas
that has a current value of only $250,000. To assume that this asset can be
safely held to maturity is absurd, when in all likelihood the borrower will
default shortly after the rate re-sets, even if the borrower has not yet
shown signs of distress. Of course such a mortgage would be completely
illiquid if one tried to sell it anywhere near par, but would be extremely
liquid if priced to reflect a more realistic value; say 35 cents on the
dollar. But if the government pays prices that fairly factors in likely
defaults, it will bankrupt the very institutions it is trying to bail out.

Another factor that has not yet been considered is that that the government
has already indicated that it will try to avoid foreclosures by reducing the
principal and interest rates on the loans it acquires to levels current
homeowners can afford. This will immediately eliminate the delusion of the
government recouping its “investment” as even if held to maturity the
mortgages will never be worth anything close to what the government pays.

Also missing in the discussion is the concept of the time value of money.
Even if a substantial percentage of the $700 billion is eventually recovered,
it will still represent a huge loss for taxpayers who theoretically have to
come up with the cash today to buy the mortgages. Further, the inflationary
nature of the bailout ensures a substantial rise in long term interest rates.
This will further suppress the present values of the low coupon mortgages the
government will be restructuring.

The moral hazard implicit in the government’s willingness to re-write
troubled mortgages ensures that the plan will spark a wave of new
delinquencies by borrowers looking to cash in on the windfall. Since troubled
loans will no longer be foreclosed by lenders but instead sold to the
government, the rational choice for many homeowners will be to stop making
their mortgage payments and wait for a better deal from the government. This
reality will eventually push the cost of this bailout well above $2 trillion.

In addition to the government bailout, distressed lenders are looking to the
suspension of “mark to market” accounting rules as a means of salvation.
These rules require institutions to value their mortgage assets according to
the most recently traded price. However, suspending these rules will not make
the losses go away. Rather it will simply allow lenders to pretend that the
losses do not exist.

Armed with such fantasies, banks could pretend that their mortgage assets had
more value, and that their balance sheets were well capitalized. They would
not need to raise more capital in order to fund new loans. But, just as a
person with no sensitivity to pain runs the risk of catastrophic injury, such
a move would encourage financial institutions to take greater risks which, in
the end, will produce more bankruptcies and greater losses.

In fact, the Senate version of the bailout bill, which authorizes a
suspension of mark- to-market, also increases the dollar limit on FDIC
insured deposits from $100,000 to $250,000 (with no extra money budgeted to
fund the increased taxpayer liability). Only in Washington would a bill pass
which simultaneous makes banks more likely to fail while increasing taxpayer
exposure when they do!

http://www.europac.net/externalframeset.asp?from=home&id=14206






  • [Homestead] bailout -- another take, bob ford, 10/04/2008

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