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Thursday, September 25, 2008


finding a fair price

now that the paulson plan is going to happen, the essential element of the action will move to center stage -- what price?

there are two schools out there now. the first -- among them at least one hedge fund manager whose call i sat in on today -- believe that the default rates and price declines such as we have seen them do not justify the excessive markdowns being applied to mortgage-backed securities in general, which are a consequence of a massive liquidity squeeze. when that squeeze lifts, say advocates, valuations will rise -- and in some cases financial companies that have marked aggressively will be in line for write-ups. evidence that third quarter writedowns will not be bad can be found in the ABX historicals -- prices for MBS have been rising for most of the quarter.

bill gross shares at least some of that logic, as does ben bernanke.

Gross said the government must find the right price between the market value of the assets they are buying and the value they have on paper at the banks holding them.

As an example, Gross said Pimco recently paid 65 cents on the dollar for a pool of mortgage-related assets. He said distressed loans and securities can trade anywhere from 20 cents on the dollar to 80 cents on the dollar, but 65 cents is a good benchmark.

Pimco expects to earn a double-digit return on its money for the 65 cents on the dollar it paid. The trick for the government is to find the right price between 65 cents and 100 cents on the dollars. The closer it gets to 100 cents on the dollar, the better banks will like the deal. But the closer it stays to 65 cents, the better for taxpayers. Gross said government must be careful and find the best compromise price, which means taxpayers will not lose money and may earn a profit.

Gross said 65 cents on the dollar assumes as many as 30 percent of the loans being purchased will end in foreclosure, and for every home that ends in foreclosure the investor gets as little as 40 cents on the dollar.

“It’s certainly possible if done right for the Treasury to make money for the tax payer,” Gross said.

goldman sachs is estimating that around $1.2tn of currently distressed mortgages are out there and potential fodder for paulson. as such, the full $700bn would vacuum up a sizeable potion of the distressed mortgages available if that is where efforts are concentrated -- though the plan emerging from congress will disburse just $250bn initially.

To arrive at this conclusion, the economists Jan Hatzius, Andrew Tilton and Kent Michels looked at the percentage of commercial and residential mortgages in foreclosure or delinquency and compared it to the total value if U.S. mortgages. They estimate that approximately 9.16% of $11.3 trillion in residential loans are at risk of not being repaid, and 4.24% of commercial loans are in the same boat.

there is another school of thought, however, part of the logic of which was embraced by paul jackson of housing wire.

Both Fed chief Ben Bernanke and Treasury chief Henry Paulson have sought to sell their plan to Congress by suggesting a dichotomy between current “fire sale” prices and the long-term “fundamental value” of an asset; the argument is that a lack of market transparency and investor fear have driven the prices of whole loans and ABS/MBS/CDO issues to levels that no longer reflect their fundamental value.

The government, they say, will buy these assets at prices greater the current market is assigning them; the idea is that in so doing, balance sheets are freed, institutions are recapitalized, and pricing discovery takes place (which, in turn, is supposed to help the prices of ABS/MBS/CDO issues recover). And thus the lending machine starts anew.

Let me make something clear, outside of the academic debate now being used to sell this bailout: if any of this junk had value, it would be trading right now. And more importantly, the lack of trading activity has little to do with a need for “price discovery,” a term being bandied about inside the Beltway with reckless abandon this week.

There is an ugly truth that Paulson is choosing to keep to himself: most already know what the prices for these sort of assets are. The problem is that there isn’t a financial institution whose balance sheet can handle selling at those prices — at least, not without putting an entire business into the side of a canyon. This is the real reason assets are clogging up balance sheets at inflated values, or put into Level 3. Or the reason that whole loans are marked at a value that in no way reflects the price that loan would receive if it was sold.

Paulson & Co. are telling Congress that the government may break even or profit from this venture, but paying an above-market price for assets valued by the market at junk levels is the pretty much the definition of how to lose money in asset management. And gobs of it, too, far more than the $700 billion figure associated with this plan.

to my mind, there is room for elements of both views. there is certainly a liquidity premium that has driven down the price of any and all asset-backed securities. however, the quality of any individual MBS is largely a function of the loans that support it, the structure of the security and its seniority in receiving payments out of principal and interest. a great many MBS and CDOs of MBS (much less CDOs of CDOs) really are worthless. a great many more are not.

chances are that the government will be presented the worst of the worst and buy it at considerably more than it is marked -- that is part of the point of the program, as defined by bernanke. so taxpayers will be paying something for nothing. while the method gross describes is possible, the reality is that banks and other bailees are going to be loath to sell to the government those securities in which they themselves see significant upside potential -- particularly if those sales mean issuing equity warrants to the government as well.

but there's a bigger danger for both banks and government here, and that is the destination of house prices. as earlier noted, bernanke's fallacy of a hold-to-maturity price as a knowable level is predicated on knowing the destination of house prices in both time and level. he does not know that -- no one does. and most banks' current estimates of the eventual decline are shy of the probability of a full reversion to and indeed overshoot of historical means of price-to-income.

as financial deleveraging continues -- something this measure can do little to abate -- credit standards will continue to be tight throughout the duration of the process. banks are trying to reduce assets, not grow them. bernanke and paulson have a stated intention to get credit flowing again from banks to companies and consumers, but even in the aftermath of a complete delevering and recapitalization (something we are nowhere near, with or without the paulson plan) the return of merely normal credit underwriting standards implies a return to normal price-to-income ratios for housing. if standards are actually tighter than the historical norm, we should fully expect house prices to fall below mean valuation metrics before volume picks up significantly and the unsold housing market inventory overhang begins to clear in earnest.

such levels could easily be another 30% lower from today; a mere return to normality is another 25% down. and that kind of downturn would wipe out a lot of MBS that most banks today blithely believe to be valuable, to say nothing of the junk that will be presented to paulson. and that will beget yet more deleveraging in financial services.

the degree of supposed validity in the idea of making money on overpaying for the worst assets at this point is, in the final analysis, a function of the degree to which one believes that housing prices will remain elevated well above historical relative valuation metrics -- which itself is a function of one's belief that credit can be made once again very, very easy for the average homebuying american.

that ease of credit was predicated not only on the balance sheet expansion of the american financial services industry, but the willingness of foreign creditors to buy private-label asset-backed securities from american investment banks hip deep in the business of securitization. i would wager heartily that neither of those features of the boom are coming back any time soon -- indeed just the opposite appears more likely.

it therefore seems more likely to me that the paulson plan, even in what might be a sincere attempt to find a fair price, is likely to lose a lot of money over time. even bill gross may end up disappointed with his return at 65 cents even on what looks today to be a sensible deal. and that, as much as pure liquidity constraints, explains the difficulty in moving asset-backed securities.

the government losing money would frankly be normal for systemic bailouts -- after all, an average one would cost the united states about $2.3tn. i'm not sure why the program should be presented as a profit center for government.

the problem is instead that the paulson plan seems on this reading unlikely to effect any of its goals by losing just several hundred billion dollars.

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