Why Banks Write Down but Don't Sell Subprime Loans 16 comments
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The market doesn’t like the Obama stimulus plan, it doesn’t like the Geithner non-plan, and it just generally doesn’t like anything.
I think the problem with all these plans is they are too complicated (even the Obama housing plan, which is relatively simple), and every Tom, Dick, and Harry (or is it Dennis, Steve, and Rick?) has an opinion as to why they won’t work. What we need is a simple plan that people can understand (bad bank) and to remove any problems (what to pay for the assets).
First of all, I want to say that the way to pay for the assets is a relatively simple thing to figure out. There is no 'second of all'; this is so painfully simple it’s annoying that it’s even discussed as an issue.
Assume that on any foreclosures you get $0, go buy a Bic lighter ($0.99, and it can be used on multiple homes) and light any delinquent homes on fire. So there are now just 3 variables: Income stream, default rates, and cost of capital.
Cost of capital should include whatever rate of return you want. In the case of the banks, something around 6% would probably provide them with a 3% net interest margin (which means their cost of borrowing is 3% and their return on the borrowed money is 6%). If it was the government you could use a lower cost of capital, since they are hypothetically not in the money making business. But 6%-- they are getting 5% on TARP-- is not an unreasonable assumption.
For income stream, I just assumed mortgage payments based on 7% interest and a $250,000 mortgage ($1,767/mo, or if there were 1,000 similar mortgages that would be $1.8mm/mo).
Default rates is where it gets tricky. In JP Morgan’s (we can still trust their data right?) latest quarterly filing they had subprime default rates at 28% and prime default rates at 7%.
Plug those numbers into a simple Excel spreadsheet (literally 3 formulas) and you can come up with the fair value for a basket of these mortgages today. Assuming 28% default rates (and that all 28% default right away), that basket of mortgages is worth 79 cents on the dollar.
If we assume things get a lot worse, and we jack the default rate up to 50% then the pool is worth 55 cents on the dollar. Keep in mind this is assuming zero recoveries from foreclosure (which may or may not be reasonable, but it is as conservative as possible) and that all defaulters default right away (again may or may not be reasonable, but it is the most conservative way to run the numbers).
What about prime mortgages? At 7% default rates those mortgages actually have a value of $1.02 per dollar of principal (this is because the interest rate is 7% but the cost of capital is only 6%). At a more aggressive 10% default rate, the mortgages are worth $0.99 on the dollar.
What this means for any individual bank, I don’t know. What I do know is it took me less than 15 minutes to figure out (obviously this is very general) how to calculate a ‘fair’ price to pay for these assets. I’m sick to death of hearing how these things are impossible to price and how we are staring into a black hole of losses for the banks. If held to maturity (which incidentally is what the guarantees for Citigroup (C) and Bank of America (BAC) are designed to let them do), these assets could reasonably be worth $0.55 on the dollar (for subprime) and $0.99 (for prime).
Timothy Geithner should put out an all or none order, meaning all banks participate. This will reduce the risk that individual baskets may have for all subprime mortgage backed securities at $0.55 on the dollar (or whatever figure he deems appropriate). Problem solved.
Incidentally, the above math is exactly why the banks do not want to sell their exposures. They don’t mind writing them down to zero (or near zero, at least on subprime) but selling them would actually crystallize a loss that they probably don’t expect to have happen. As the loans run off (especially now that refinancing will be less of an issue with the housing stimulus plan) the bank may actually book gains relative to marks (depending on how aggressive those marks were).
So we end up stuck in no man’s land: No one is willing to buy them (the cost of capital, including return, for people buying this would be closer to 15-20%) at the price the banks know they are worth.
If the private/public partnership were to take place, it’s likely that cost of capital for buyers could be dramatically reduced. The government provides financing at say 3% for 90% of the value, then the blended cost of capital would be closer to 5-7%. But I’m not sure why that’s better for taxpayers.
There is a nice 10% cushion on downside, but the taxpayer would be giving up the vast majority of any upside (unless you count the low interest rate).
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This article has 16 comments:
Everyone keeps saying that 92% of the mortgages are being serviced and paid on time, so here's a thought:
Why not apraise those Legacy assets at the current rate of NON default which is now around 92%.
I bet that the banks will sell then.
Why the hell should a group of people who made a fortune by engineering the so-called 'worthless' assets collapse, now be able to make anoher fortune by buying all those assets that are now 'worth_less', up on the cheap. BS
Greed on the way up, but worse greed on the way down.
On Feb 24 07:03 AM atlasman wrote:
> Could someone please explain to me why there has been so much opposition
> to changing m2M to some form of an accepted model. As a minimum I
> would think that would the world better understand the magnitude
> of the problems.
So I am pretty sure the banks don't know what they are worth. Just as the stock markets are on a crazy downward spiral, so too are home values with little predictability save the laws of gravity. Unemployment rising is adding regional variance to the mix.
And this is just mortgages. Roll in the other collateralized debt and the problem moves again. Don't trust the marks.
Then there's the CDS's on the defaults owned by other institutions where the premiums were leveraged. How does one plug that risk into Excel?
It's quantum mechanics.
Therefore, you don't know what the credits are that are in the CDO. Since CDSs are built to offset risk of CDOs, you don't really know how the CDSs should be priced.
Now, think about the logic of your spreadsheet. The discount rate for each cash flow stream should be adjusted for risk.
Makes it a little more challenging, and that ain't the half of it.
Tie them into the FACILITATORS in govt, and the picture becomes clear!
Cramer has all but spelled it out on his show. Invite him to Congress to testify with NAMES & FACES & METHOS & MEDIA........
It's called the FLEECING OF AMERICA...........ON PURPOSE!!!!!!!!!!
That's why there is such forces against changing it...........
DUH!!!!!!!!!
Now, if the govmt is afraid to overpay and banks are afraid to get underpaid and they still want to create such a bad bank, just start with assumptions like yours and put a provision in the plan to review the prices every year or six months. Since we would be de facto into a fair value accounting system, it should be affordable to everybody.
And this starts with Bill Ackman and his take down of MBIA & Ambac. In order to do that his only alternative was to try and prove that heir CDO's were worthless. By what has got to be the greatest fleecing & rumorboarding of all time, he convinced everyone that every mortgage backed the their CDO's was or was going into default. That was 2 years ago, and the default rate nationwide still is only around 8%.
Go back to the beginning and the entire crisis becomes very clear.
let's sing the short sellers theme song one more time:
"No.. no.. no, it ain't me babe! It ain't me you're looking for.. babe!"
bullshit
On Feb 24 08:18 AM eddie6442 wrote:
> The question isn't "what" has been done, but WHO DID IT AND WHO BENEFITTED?
>
> Tie them into the FACILITATORS in govt, and the picture becomes clear!
>
> Cramer has all but spelled it out on his show. Invite him to Congress
> to testify with NAMES & FACES & METHOS & MEDIA........
>
> It's called the FLEECING OF AMERICA...........ON PURPOSE!!!!!!!!!!
>
>
> That's why there is such forces against changing it...........<br/&g...
>
> DUH!!!!!!!!!
You haven't accounted for depreciation and lost value on these assets.
Plus the "crystallization" you refer to will become cemented when the bank goes through purging the house at a 50% of the original loan
When a loan defaults, it's not worthless. The bank put the property on short sales and recovers at least 50% after fees etc.
Let's go through a few problem factors (and they're not little), one by one:
1) Really, just find the "fair" value by assuming torched houses? You do realize that the reason why we're having trouble with these ideas is because we want to actually RESTORE financial integrity to the banks, right? Sure, it'd be easy to do this in a way that we radically undervalue the assets, but the idea was to get the banks healthy again, not just kill them quicker.
If we wanted to do that, why didn't we just say, "these assets are all now worth zero"—that'd be even faster, wouldn't it?
2) Like some people pointed out, if you are looking for an evenly mildly fair value, you have to realize there's still collateral under these things. The value might be falling, but they're sitll worth quite a bit.
3) It may work in pronouncements and vague generalities, but in the real world, we can't just hand-wave and "assume" that your income stream is based on variables that aren't easy to accertain and aren't necessarily constant.
One of the things that dropped us into this mess, and LTCM management was the fact that people stupidly assumed that financial variables (volatility and correlation respectively) will stay constant.
If you just hand-waved like that for a finance class, the professor would fail you, let alone try to apply this to actually valuing these things.
It sounds like that you're saying, "If we just have a plan, any plan, even a horrible plan," then everything will be fine.
I disagree. We can make things far worse. For instance, by putting into effect your suggestion.
All those factors play into the value of the mortgage. However assuming the mortgage was current for part of its life, even at $0.55 on a 6% $250,000 mortgage in a sale today, if that mortgage is in its fourth year and defaulted within the past 12 months, the bank still has made $0.77 recovery before cost of sale when you take into account the three years principal and interest for the none default period of the mortgage.
If there is in fact even the smallest of owner equity left in the $0.55 equation, the bank does better. The point is the bank will do better than $0.55 before expenses, which I suspect are also part of the $0.55 book value calculation on the part of the bank in determining the value of the mortgage before sale.
Knowing 30 c on the dollar for the super senior trench is artifically deflated by market forces, bank are not willing to sell. But buyers, knowing even 50 c on the dollar is good value, but cannot buy it without financing (got to leverage up at least 8 times to make enough money). All the potential buyers can do is lowballing bid. with plenty liquidity going on in the market, banks does not need to unload to get liquidity.
with the improvement of housing affordability and historic low mortgage rate for refinancing, eventually the rate of foreclosure will level off wich will then force distressed assets buyer into the market, offering a 50c on the dollar. The revival of corporate bond market, the continuing buying up agency bond by the Fed, the upcoming 1 trillion TALF program and the 275 billion foreclosure prevention program might eventually unlock the jam.