Bailout Talks Lose Sight of the Cost Question 27 comments
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Andy Kessler reckons that if the government buys up bad loans at 35 cents on the dollar and eventually receives 50 cents for them, it could make well over $1 trillion on this bailout. I'm not sure how that works: a 43% return on $700 billion is a profit of only $300 billion.
In any case, it seems clear that even under Kessler's optimistic scenarios, if the government buys bonds at about 60-65 cents on the dollar -- which is very much within the realm of possibility, listening to how Ben Bernanke described the bailout -- then the taxpayer is liable to be on the hook for a very large sum indeed.
All of which only goes to reinforce the central irony of the bailout negotiations. While the politicians argue about things like executive pay and insurance funds, there's only one thing which really matters: the price the government pays for bad assets.
Paulson and Bernanke are leaving that key number deliberately vague, while the House Republicans' plan seems to envisage ultimately paying a full 100 cents on the dollar, through a new insurance fund, with some unknown part of that payment coming from the banking industry itself. Either way, the cost of the plan is very much up in the air. But for reasons I don't pretend to understand, the real sticking point of the negotiations is the "how", and not the "how much". Weird.
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In the short term, the bad assets are moved off the companies, replaced by equity in the new company. The immediate pressure comes off, and the market determines the actual values over time. I might not be describing this quite right, but the idea's a nice twist.
Of course, if they'd just rescinded the mark-to-market requirement early this year, we might not have reached this point...
Part of the problem is that nobody knows what they are "worth" but as the saying goes "it's only worth what someone is willing to pay for it" so mark it to market!
I certainly won't be loading up my portfolio with this junk and I resent the hell out of being forced to purchase it by the government.
Oh yeah, the so called "financial rescue" won't work on any terms that don't cost the taxpayer a bundle.
This is flawed reasoning. If the assets are fairly valued at .35 then the assumption is that not all of the assets are performing. Afterall, the reduction in price is not due to a rise in interest rates, but the amount of defaults. In fact, given a fixed reasonable rate of return the price implies that only about 35% of the loans are performing. You still get only 6% of the pie, but now the pie is 65% smaller. (This is a highly simplified back-of-the-napkin calculation only, to show the fallacy of the argument above) Furthermore, if the bailout actually occurs, the 6% rate may not be enough to offset the rampant inflation that will ensue.
The problem is that there are no willing buyers nor sellers at an agreeable price, so there is no market. A deficit of buyers at a certain ask does not automatically mean that the sellers are wrong about the price. Furthermore, the mark to market is only a rough approximation of the value. If you sell 1 unit at $1000 that doesn't mean that you'll be able to sell 1000 units at that price. However, the mark to market approach implies the opposite.
That doesn't alleviate the need for valuing the assets to determine how much equity the banks can put back on their balance sheet. Unless of course, we come up with an imaginary number, say full value (as good as any other estimate), and let the banks put that up in their balance sheets.
I am not a distressed structured bond analyst, so I can't say for certain what is behind the price of these bonds or what is the fair price. What I can say, though, as a corporate credit analyst/trader, is that the corporate credit market is currently substantially impacted by many technical facotors (banks having to sell down risk, hedge funds liquidiating, indiscriminate selling of any risk assets on headline fears, and momentum-chasing considerations.
I suspect (but don't know) that these factors are substantially worse in the more illiquid MBS market. I suspect that yields and credit spreads for these assets reflect a liqidiy and risk premium substantially higher than what is actually justified from current or expected default rates.
Having said that, yes my 18% yield comment is simplistic, but you get the point: there is a running yield on these bonds that I suspect is substantial (maybe not 18%, maybe less, maybe more). 18% would be consistent with the yield of many high-yield bonds which currently have strong cashflow (after servicing their debt) and solid businesses, but are oversold for fear/liquidiy reasons.
43% return on $700 billion does not net $1 trillion unless you are mathematically illiterate
The present value of the interest payments is next to irrelevent -- unless you are a Wall Street "analyst" and forget to take the present value of the interest costs... This ranks right up there with EBITDA -- or the most recent Wall Street stupidity: earnings before all costs.
Wall Street needs to learn some basic math skills.
Wall Street needs to learn some basic math skills. Well, if you are the Treasury and receiving (hypothetically) 18% in annual returns (which incorporates expected interest payments less expected default losses) on your investment and your cost of capital is 3.5%, is the present value of your annual payments really 0? Also, I believe the statement was that they would make 1 billion -- that is an absolue amount, not the NPV of future earnings.
Maybe NPV is more relevant, but get your facts straight and get off your condesending high horse. Actually, strike my last comment, I agree that most analysts on Wall Street are morons and need some basic math lessons.
Buffett is collecting 11% on Goldman prefferred stock-- he didn't even touch the mortgage bonds
The treasury will not receive 18% or anything even close. If a home owner defaults on their loan (something that those of us without an MBA seem to have figured out is happening) -- they don't make payments... This next mental step is probably too big for a Wall Street analyst to grasp, but work with me here: if the home owner isn't making payments-- the bond owner isn't getting ANY interest payment.
The article cited (click through the link) says that the Treasury will **NET** one billion. 50/35 * 700 billion comes out to one trillion GROSS. Kessler neglects to subtract out the 700 billion cost, which (even if you agreed with his numbers) would leave you with only 300 billion profit.
Earlier posters were suggesting that the difference (the other 700 billion) was the NPV of the interest payments... Treasury OAS on high quality mortgage bonds is a couple hundred basis points, not 10000+ basis points that you would need to net one billion in profit.
On Sep 26 05:13 PM tvb wrote:
> Having said that, yes my 18% yield comment is simplistic, but you
> get the point: there is a running yield on these bonds that I suspect
> is substantial (maybe not 18%, maybe less, maybe more). 18% would
> be consistent with the yield of many high-yield bonds which currently
> have strong cashflow (after servicing their debt) and solid businesses,
> but are oversold for fear/liquidiy reasons.
I was referring to my calculations as simplistic. I don't think you are looking at this all wrong. There may be an 18% yield on the performing loans, but the CDOs contain both performing and nonperforming loans. What I attempted to convey by making some grossly simplistic assumptions was that the ratio of performing to non-performing loans within the CDOs might just be the same as the ratio between the current "market value" and par. In such case the rate on the CDOs is the same as the rate on the performing mortages, that is 6% and not 18% (i.e. non-performing mortgages are assumed to have 0 value and make 0 interest payments).
> The treasury will not receive 18% or anything even close. If a
> home owner defaults on their loan (something that those of us without
> an MBA seem to have figured out is happening) -- they don't make
> payments...
This is precisely my point. They will not pay the principal and thus the 35% valuation on the CDOs, and they will not pay the interest which brings the CDO coupon back to 6% (which, at least in this voodoo economic case, is equal to the average interest rate on the underlying performing mortgages).
Wall Street has made plenty on these deals, paid out the profits to their staff and then the firms were caught short of capital when the deals went south. Many of the big winners, like Mr. Paulson, took their chips and went home. Now we are asking the guys who had the luck to participate, make a lot of money, evidently not object to what was going on and the good fortune to leave early, to come back and clean up the mess they made. I love this country!
Lo and behold, GS, MS et al are lining up to get a piece of this very big $700 Billion pie. With friends like this who needs enemies?
Regular folks who have lost their homes, jobs, etc are saying "let 'em fail". I guess they are upset because no body bailed them out from their bad decisions.
I'll give you a ancedotal comparison. High yield bond funds were selling below 200bps at the height of the credit bubble in 2007)...today that spread is closer to 700 basis points (500bps above where they were at the peak). That reflects the yield on the PERFORMING bonds...an apples to apples comparison to the yield a the peak. On top of the higher yield, the value of the principal (of the remaining loans) is now about 20% lowe, giving you higher recovery prospects on the bonds that do default in the future. The same would be true for a MBS...you would have a yield on the remaining performing secuirities which is I expect is al least 500bps wider than it was at is peaks (so you are talking a runiing yield of maybe not 18%, but at least 11% and I suspect actually closer to 18% given the liquidiy and technical factors currently impacting the market).
As for "why the distressed buyers sitting on cash aren't buying these if they offer such great return". Technicals...every bank in the world is over exposed and trying to reduce exposure. Furthermore, there are few true-long buyers on WallStreet...most are chasing headlines and momentum as they have to mark to market their positions daily and their investors don't have the patiernce to just sit and watch their investments fall because they are told they are "good long term value"...particularly for securities that the underlying investors, a step away from the market, don't understand.
What's happening in many credit markets, today, is like a reverse bubble...everyone knows they are oversold/cheap but can't afford to go long (or are often even short these securities) because they feel that short-term technicals will lower prices further...irrespective of the long-term value. It's like the reverse of what happened in early 2000, when many smart investors were long TMT stocks even though they knew they were vastly overvalue (they simply had to chase momentum and trends).
Disclosure: I do not follow or analyse these MBS securities and I am simply extrapolating from what I have seen in the corporate credit markets. I do not ruly know if these MBS securities are oversold, but strongly suspect that this is the case.
Sure did. And this week they went on the record saying how they'd avail themselves of the bailout if they could. 'Send me your poor, your huddled...no, wait a minute... your bundled masses...' That's a globalised world for you.
Long term investors focus on cash flow, the internal rate of return (compounded) that said cashflow generates, and how that IRR compares to both their cost of funds and to other investment opportunities.
Since homeowners aren't making payments, there are no cashflows. Valuing these things at 30-35 cents on the dollar is saying that the other 65-70% default. That means they don't pay principal AND they don't pay interest. The 30 or so percent that do pay are going to be paying their mortgage rate (around 6% plus or minus). From that 6%, you still have to subtract future defaults, which will not be zero... and all this "analysis" assumes that one is able to correctly identify which loans will pay and which loans will default -- Wall Street has proven that they are unable to do this. Buffett has said he doesnt think he is able to either. Distress investors have not expressed any confidence in their ability either.
It is absurd to suggest a bunch of government bureaucrats, led by Hank Paulson, are going to be able to properly value these assets.
The only way to help the banks is to overpay for the assets (in which case taxpayers incur a huge loss).
If the tax payer makes a profit, it will mean the banks have to take even more write downs -- and they are already capital impaired as it is.
Paulson's plan is a terrible idea and should be thrown in the recycle bin. Rather than rushing through a terrible, poorly thought out plan, we need to wait until January when a new set of faces can come at the problem with new ideas. Paulson has no credibility left, and he knows he is leaving so his heart isn't in the game at any rate.
Treasury announces an auction of say $100B and break it into 4 categories - subprime, option-arm, other prime and home equity. Each category is broken into classes that give granularity to the underlying markets of pools that make up each MBS. Could be many per category, but lets say there are 5 per category for a total of 20 'bidding' traunches.
But it is a reverse auction, so they are 'offer' traunches. Each holder offers a price they will take for $X face value of MBS's to derive a pennies on the dollar price. For each traunch, the Treasury takes the lowest price and works upward until the total dollars allotted to the traunch have been reached. Thus 'we the people' get the best and lowest price and thus the best upside potential as the Treasury can hold the MBS's to maturity.
The prices will be higher than where institutions have been dumping and thus marks to market will be higher. So the holders of all similar MBS's will recover asset value and the credit markets open up.
But here is what will happen after the first auction - hedge funds and vultures will offer to buy the MBS's the Treasury just bought! Why, because the auction established floor prices. Thus the Treasury makes a quick profit and recovers part of its $700B in purchasing power - yes it revolves!
When the next auction is held, there could be lower prices in some traunches [but not likely] as some whose offers were not accepted the first time will make sure they get accepted the second time as they MUST get cash.
The taxpayers will make out like bandits - but the Treasury cannot say this publicly.
[note: JP Morgan gave some insight as to values of the 4 categories each in aggregate as part of their evaluation of WaMu. In a sense, they set a floor price.]
Paulson pulled out the bazooka because of the seizing of commercial paper and not because of GS losing value, that was an effect of the collapsing credit markets. They had the bazooka all the time as simply an outline and had considered many other alternatives including, briefly, the non-workable insurance plan. The plan offered was purposely an outline as only Congress can add the flesh - as they are doing.
There is no need for punitive actions against the institutions holding the MBS's - they are selling at the lowest price - that's punitive enough. Remember, the institutions include pension plans, insurance companies - not just banks! They thought they were buying the best rated traunches and still found out the value has dropped. They acted prudently with the information given to them by the rating agencies. So some would want these institutions that hold the people's retirement and annuity money to give a piece to the Treasury?
This will liquify the banking system, but will not prevent recession.
THEN... then you suggest the Treasury is now placing a floor on the price of the assets. Hedge funds can buy them from the Treasury knowing the price "cannot" go below what the Treasury paid.
So in essence, you are proposing that the Treasury sell call options for free/cheap to hedge funds? heads, the assets go up and the hedge funds make even more money, tails the asset prices go down and the hedge funds stick the taxpayer with the problem again?
They say a fool and his money are soon parted... Its becoming clear the US taxpayer is about to part with a LOT of money
Well, gramps, I don't think that the case is as simple. As I have stated before, this is a grossly simplified estimate based on the assumption that the current mortgage rates to the non-defaulting borrowers would be the same to those borrowers today. I agree with tvb that there may well be a spread, however no one has yet shown what those spreads are. Although tvb speculated as to their existence, tvb disclaimed any actual knowledge. Furthermore, 30 year mortgages according to bankrate.com hover today around 6%. So although I agree with you as to the results based on my very general assumptions, I disagree with you as to the valuation methodology which in your case takes my assumptions for granted and in my case is simply an assumption for lack of sufficient data.
jbde wrote: "Thus 'we the people' get the best and lowest price and thus the best upside potential as the Treasury can hold the MBS's to maturity. "
This statement is a falacy. What "we the people" will get is the lowest ask, not the best and lowest price. The best and lowest price would be the fire sale price however irrational that price would be. The banks have already shown an unwillingness to reduce the prices of those assets below certain thresholds. Furthermore, we have no insight to evaluate whether those prices are reasonable, and the lack of interest in the paper at those prices, assuming that "markets are always right", suggest that the prices are not reasonable and thus far from being the best and lowest.