Why Banks Write Down but Don't Sell Subprime Loans

Feb. 24, 2009 5:20 AM ETC, BAC, PJB, KBE, KRE, RKH, IAT16 Comments
Nick Abe, CFA profile picture
Nick Abe, CFA

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

This article was written by

Nick Abe, CFA profile picture
I am currently a market strategist and portfolio manager for the Alpha Macro Strategies Fund. After graduating from the University of Western Ontario with a BA in economics, I successfully completed the CFA program in 2007. Through ten years of experience in the industry I have come to realize my strengths and weaknesses. While my batting average for "correct" ideas is very high (you can scroll through my previous articles for an idea), my timing is not always the best. I tend to only get interested enough in investing in things (stocks, commodities, markets, whatever) when they have reached an extreme. Unfortunately these investments bring big volatility along with big opportunity. So it might make sense to average into any ideas mentioned (as I've learned to do through a series of very painful lessons). Also if you're wondering why my gap between articles is so large, it is mostly due to desire. I only write when I have strong feelings on something and I tend to only have strong feelings on things when people are loudly espousing an opinion opposite to mine.

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