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September 25, 2008

"Some Dude's" Thoughts on the Toxic Asset Purchase

I'm going to admit that I don't get everything he's saying, but I get some of it.

I don't know dick about duck, but it makes sense to me. For what little that's worth.

Part 2 is interesting. Note that part of the reason these assets are being driven down closer to zero is due to what is, frankly, gaming the system by hedge funds and other big investors, driving the prices down in order to force a sell-off. That's not illegal (yet), and yes, it's the fault of holders of these assets to have exposed themselves to this sort of risk, but the point is 1) "unnatural" forces, if you will, are causing these assets to be undervalued, 2) upside pressure on the price will stop this just the same as drilling for new oil in the US will stop oil market speculators from driving the price of oil up, and 3) the US government appears the only entity in existence with the financial muscle to halt this.

There are two major factors that contributed to this whole mess:

1 - FASB 157 - 157 is the marked-to-market accounting provision that stipulates that a security must be valued on the books by the holding firm based on the last arm's length trade of a similar instrument. While this is well and good for companies outside of financial services, the I-banks and larger commercial bank's balance sheets only consist of loans and securities (assets) and cash, deposits, loans from banks/Fed (liabilities). Equity is the appreciation of the securities and any undisbursed profits. When the value of a security, in this case a mortgage backed security (MBS), collateralized debt obligation (CDO), etc. is traded below their book, they must mark it to market and adjust capital requirements as needed. Let's leave this part alone for a second...

2 - Liquidity. As securities fall in value and capital requirements are adjusted, firm must reserve more cash to shore up investor confidence. This can come from existing cash assets, but also from new rounds of capital raising from outside investors. Liquidity, CASH, is king. Everyone knows that, or at least should.

Now, as securitized assets, notably subprime MBSs and CDOs, began to default and cash had to be reserved that lead to a flow of cash out of new investing activities (making loans or buying MBS/CDO) and into shoring up balance sheets. This lead to a decrease in demand for MBS and CDO, thus lowering the price, thus creating another capital call. It began a vicious cycle, if you will. Now, some banks who were illiquid and subject to capital calls began disposing of these assets at fire sale prices, thus driving the mark-to-market price down for everyone who held them, contributing to the vicious cycle. Further, investors who were liquid and not experiencing capital calls were shorting these securities in the market driving the price down further. Why? Because they knew that by shorting them it would exacerbate the vicious cycle in such a way that holders of them would at some point be forced to sell to stop the bleeding. Further, by shorting the stocks of the institutions holding these assets, this eroded capital in these institutions thus leaving them without the capacity to hold these securitites to marturity. That last bit, holding to maturity, is the important part.

All told MBSs and CDOs trade somewhere around 10 cents on the dollar. The I-banks and money center banks (Citi, BoA, etc.) due to the declining valies didn't have the cash to hold these instruments to maturity. Further, if they could, due to the perceived risks in the market, their investors would require large internal rates of return, probably somewhere north of 20%.

The things Paulsons's plan accomplishes are several:

1 - Given the revenues of the Gov, and the abliity to print cash, they have the capacity to hold these securities to maturity, thus allowing them to stabilize and get sorted out. The market had MBS and CDO priced at 10% of par value, a decline of 90%. Duh. Why so low? Because of the vicious cycle the potential purchasers and short players KNEW that the firm holding them would break at some point and not be able to hold to maturity.

2 - In RE investing the "magic number" is somewhere around 60%. That is, ON AVERAGE, if a bank makes a mortgage loan at 80% of the asset they will, on average, recover 60% of the asset value upon completion of foreclosure and liquidation, a loss of 25% of principal at risk. Now, if the MBS are trading at 10% of par value, and based on the magic number that prices in a loss rate of 90% of principal, something is amiss. By being able to hold these securities to maturity and provide for an orderly liquidation of the underlying assets (houses) the Fed accomplishes a couple things. Notably, they don't have to throw all the houses that warrant foreclosure on the market at once, thus allowing some absorption of existing inventory, thus maximizing the potential recovery and minimizing loss of principal. Also, it gives them the ablity to write down or modify other mortgages to prevent foreclosure, which would prevent more inventory from hitting the market, thus further stabilizing the housing market AND keeping people in their homes. Of course, the Dems won't concede this fact as it gets in the way of seeking more housing subsidies and other socialist ends.

3 - The Fed has no required internal rate of return (IRR). Typically, assets looking to purchase distrssed mortgage paper or CDOs are seeking a IRR north of 20%, and more typically 30%. As such, they needed the price of the assets to be much lower before they would take on the risk of working out the paper and the underlying debts versus the Fed. Example: Private investor purchases MBS at 30% of par value, reaches the magic number of 60% and realizes a 30% IRR. The Fed, on the other hand, can purchase them at 40-50% of par value (the strike price being floated around the Street), hit the magic number of 60% and realize a 10-20% IRR. Still, not to shabby AND the Treasury realizes all of that return, which on $700B would be $70B on the low side.

Is is a use of taxpayer funds outside of the mandate of the Government? Sure.

Is it the best option we have at the moment? Probably.

FYI, Carlyle Group, another entity with lots of cash and the ability and expertise to hold these securities to maturity and work out the disposition and write downs to stabilize the cash flows servicing the securitites, has already contacted the Gov to "help out" with the management, or outright purchase of the securities, under the Paulson plan.

Gabe, I ususally like what you have to say, but you get several cause-effect relationships backwards. Leave economics and financial analysis to those of us that are economists and finaciers.

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posted by Ace at 02:25 PM

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